By Steven Scheer
JERUSALEM, Jan 5 (Reuters) - The Bank of Israel unexpectedly cut its interest rate by 25 basis points on Monday, a second successive cut after lowering it in November for the first time in nearly two years, citing an improving inflation environment after the Gaza ceasefire.
The benchmark short-term rate was reduced to 4.00% from 4.25%.
Bank of Israel Governor Amir Yaron said that despite the two cuts in a row, policymakers would remain cautious and mindful of economic and inflation
developments and that the monetary committee's base scenario was for the key rate to slip to 3.5% this year - two more 25 bps reductions.
He told a news conference that three factors contributed to the decision to lower rates again - easing inflation, a shekel that has reached a four-year peak versus the dollar and declining supply constraints.
SIGNS OF FEWER LABOUR MARKET CONSTRAINTS
"Since the ceasefire (with militant group Hamas), there has been a change in the inflation environment," Yaron said.
Supply constraints had stoked inflation during the two-year war in Gaza that ended with a U.S.-brokered ceasefire in October 2025 but the annual inflation rate eased to 2.4% in November, within the government's 1%-3% target range.
"While the labour market is tight, there are signs of moderation in supply constraints in the labour market," Yaron said.
He also pointed to declining inflation expectations in the bond market and the stronger shekel, in which the currency's appreciation supports lower inflation levels.
"These three factors together contributed to the decision to (cut) now rather than a bit later," Yaron said, also noting that Israel's risk premium has moved back to near its pre-war level.
The bank's forecasters projected that there would be an increase in inflation when December's data is released by the statistics office on January 15, and it would then decline to around the midpoint of the policy target range.
NEXT DECISION DUE FEBRUARY 23
Despite easing price pressures and a four-year high for the shekel against the dollar, nine of the 10 economists polled by Reuters had forecast the central bank would hold rates this month. One economist expected a quarter-point reduction.
The next decision is slated for February 23, after both the December and January inflation figures are published.
The shekel was up 0.8% against the dollar at a 3.157 rate, its strongest since December 2021. Tel Aviv share indexes rose as much as 1.6%.
In updated forecasts, the central bank projected economic growth of 5.2% for this year after a 2.8% pace in 2025 that was held back by the war, and an inflation rate of 1.7% in the coming year.
Yaron also urged lawmakers to approve the 2026 budget. While it has received cabinet approval, it was not yet clear whether it will pass parliament due to political infighting. Failure to pass the budget by the end of March would trigger a new election.
Still, Yaron said the planned deficit target of 3.9% of GDP was too high.
"Complying with this deficit target depends on ... there not being geopolitical developments that will require an additional increase in defence expenditures and that the assumptions in the revenue path will in fact materialise," he said.
(Reporting by Steven Scheer; Editing by Toby Chopra, Tomasz Janowski and Alison Williams)
