(Bloomberg) -- Israel will diverge even further from the policy path set out by the Federal Reserve if most economists prove right and the central bank cuts interest rates again to help the war-hit economy.

The Bank of Israel already broke with its US counterparts in cutting rates to start the year, after a long stretch when it largely followed the Fed’s lead in bringing borrowing costs to their highest since 2006. But priorities changed in the aftermath of Hamas’s attacks in October, a shock that led to a near-record economic contraction last quarter with inflation remaining subdued.

Even so, Israel’s rate decision on Monday looks like a close call. There’s a split consensus among economists, with most global banks from Morgan Stanley to Goldman Sachs Group Inc. predicting a cut of a quarter percentage point to 4.25%. 

Analysts at top Israeli lenders such as Bank Leumi and Bank Hapoalim are in a minority in a Bloomberg poll of 17 forecasters seeing a hold at 4.5%.

Morgan Stanley economists including Alina Slyusarchuk said they expect Israel’s central bank “to take measured steps in normalizing monetary policy conditions.”

At the same time, “economic risks related to the ongoing conflict remain in place while global financial conditions have tightened recently, which could amplify risks of FX depreciation and lead the Bank of Israel to err on the side of caution,” they said.

Economy, Inflation

The central bank’s monetary committee will need to grapple with economic cross-currents facing Israel.

A slowdown at the end of last year contrasts with signs of a quick rebound so far in 2024, especially in private consumption and a labor market that’s seen unemployment fall sharply since a spike in October. The Israeli Purchasing Managers’ Index in January shifted back into expansion from contraction, according to Bank Hapoalim.

A ramp-up in government spending also raises the risk of sticky inflation, especially if worker shortages endure. The future course of the conflict presents the biggest uncertainty of all, highlighted by the threat that the fighting could spread along Israel’s northern border where its military has been exchanging fire with Iran-backed Hezbollah.

Relative calm has so far prevailed in Israeli markets, despite a downgrade earlier this month by Moody’s Investors Service, Israel’s first-ever sovereign rating cut. 

Since the decision, the shekel has been the second-best performer among a basket of 31 major currencies tracked by Bloomberg, a rally helped by gains in global tech stocks. It’s trading at a level stronger than before the war, up more than 12% after reaching an 11-year low in late October. 

“While uncertainties surrounding the conflict and a large fiscal deficit adds to hawkish pressures, we think that the near-term inflation developments as well as the recent FX performance will support further gradual rate cuts by the Bank of Israel, although we see risk skewed towards a more cautious outturn,” Goldman economists led by Kevin Daly said in a report.

Following a reduction of 25 basis points in January, Israel’s central bank gave no clear signal about the timing of what it plans to do next. Its research department projects the interest rate at 3.75%-4% in the fourth quarter of 2024, an outlook that Governor Amir Yaron has said could imply as many as four cuts this year.

Annual Israeli inflation was slowing or unchanged in all but one of the past 12 months, entering the government’s 1%-3% target range for the first time in over two years. While a surge in government spending on the war is a risk for prices, inflation has been largely immune to supply shocks linked to the conflict with the exception of a brief increase in food costs.

Fed officials have recently made clear they are in no rush to reduce rates. Several policymakers at the European Central Bank are also stressing that monetary easing can’t begin until more data arrives in the coming months. 

Yet even as Israel’s differential with the US is shrinking, its policy rate is near 2% when adjusted for inflation, comparable to Canada’s and a bigger buffer than in developed economies from the UK to the eurozone. 

“Moving away from the Fed route should not be an obstacle as long as it does not affect the exchange rate of the shekel,” said Alex Zabezhinsky, chief economist at Meitav DS Investments who forecasts a 25 basis-point decrease. “The Bank of Israel’s fears about threats to financial stability are not materializing, at least for now.” 

The reluctance of many global central banks to ease policy may still be a factor for Israel. Economic risks from the war in Gaza, now raging for over four months, are also a worry for policymakers, with little consensus over when the conflict might end.

“Due to heightened geopolitical uncertainty, the delay in Fed cuts, gradual economic recovery and the Bank of Israel’s cautious communication, we think a pause is more likely,” Barclays Plc economists including Brahim Razgallah said in a report.

--With assistance from Joel Rinneby.

(Updates with economist comment in final paragraph.)

©2024 Bloomberg L.P.