(Bloomberg) -- Israel’s central bank left interest rates unchanged, as the prospect of easing grows more remote for an economy whipsawed by war.

The monetary committee kept its benchmark at 4.5% on Monday, in line with the forecasts of all economists surveyed by Bloomberg. The shekel briefly pared its earlier decline before reversing and trading about 0.5% weaker against the dollar as of 4:50 p.m. in Tel Aviv. 

In a statement accompanying the decision, policymakers largely repeated their neutral guidance from April, without indicating the likely direction of their next move. But they warned of a range of threats to inflation and said they expected a continued increase in the budget deficit over the coming months.

Israeli policymakers, who earlier signaled as many as three more cuts in 2024, have turned more cautious after a rate decrease to start the year. The change of tack is in large part a reflection of economic spillovers from the war against Hamas that’s now dragged on for more than seven months.

Citigroup Inc. no longer expects Israel to resume reductions this year and Bank Hapoalim calls them “far from certain.” Traders have also unwound bets that further easing is imminent.

The central bank said “the Committee’s assessment is that there are several risks of a potential acceleration in inflation: geopolitical developments and their effects on economic activity, a depreciation of the shekel, continued supply constraints on activity in the construction and air travel industries, fiscal developments, and global oil prices.”

A ramp-up in budget spending is feeding through to inflation that’s approaching the top of the government’s 1%-3% target range after a two-month acceleration. A likely later start to rate cuts by the US Federal Reserve will probably shift the timeline for the Bank of Israel’s easing as well.

A wider rate differential between Israel and the US threatens capital inflows and could undercut the local currency. Though the shekel has recently recouped some losses suffered in March-April, its three-month historical volatility at over 10% trails only Chile’s peso, the Russian ruble and South Africa’s rand among a basket of 31 major currencies tracked by Bloomberg.

Israel’s war bill has already amounted to $16 billion, swelling the 12-month trailing budget deficit to 7% of gross domestic product as of April. Bank of Israel Governor Amir Yaron has repeatedly called on the government to adopt a responsible fiscal policy in the face soaring defense outlays. 

On Monday, the central bank said it expects the cumulative annual deficit “to continue to climb in the coming months, and to converge back to an environment similar to the current one toward the end of 2024, provided that there are no notable deviations in security expenditures.”

Price pressures are intensifying just as the outlook dims for Israel’s economy after a bounce-back in the first quarter. The conflict’s duration and intensity present the biggest uncertainty, with the military now expanding operations in Rafah against Hamas and still engaging in combat against the Lebanese militia Hezbollah in the north..

Industries from construction to retail trade remain swept up in the disruption from the fighting. As a result, economic growth is on track to moderate in the coming quarters even as GDP remains 2.8% below its pre-war level. 

While the Bank of Israel projects the economy will expand 2% this year, S&P Global Ratings and Moody’s Investors Service see a much weaker pick-up closer to 0.5%-0.6%. 

But the central bank has less room for stimulus now that inflation is reviving, in an upswing that took it to 2.8% in April, the fastest this year. A survey by the central bank found expectations for price growth a year ahead inched up for a fifth straight month in May and reached 3%.

Faster increases in the cost of food, especially dairy products, will likely keep up the momentum of inflation this month, with the cost of air travel also sharply on the rise. 

“The Bank of Israel chose to avoid substantially directing the market’s expectations one way or the other,” said Yonie Fanning, chief strategist at Bank Mizrahi Tefahot’s Finance Division. “It is likely that we will see a correction in interest-rate expectations moving forward, but we will have to wait for more stability in the markets before that happens.”

--With assistance from Joel Rinneby.

(Updates with analyst comment in final paragraph.)

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