By Steven Scheer and Ari Rabinovitch

JERUSALEM (Reuters) -Israel’s economy will take a hit from the war against Hamas but should quickly recover, Bank of Israel Governor Amir Yaron said on Monday after the central bank left short-term borrowing costs unchanged for a third straight decision.

Yaron said policymakers spent two days discussing the economic effects of the war but opted to leave the benchmark interest rate at 4.75%.

The committee had raised rates 10 straight times in an aggressive tightening cycle aimed at battling inflation, that has taken the rate from 0.1% last April before pausing in July and again in August.

“I’m pretty skeptical that at the moment lowering the interest rate would make demand jump,” Yaron told a news conference.

Officials have cautioned that steep rate cuts at the moment could further weaken the shekel, which is already at an 8-1/2 year low versus the dollar, and push up inflation.

The inflation rate eased to 3.8% in September from 4.1% in August but remained above an annual target range of between 1% and 3%. In updated forecasts, the Bank of Israel’s economists projected inflation moving to a 2.9% rate in the coming year and to end 2024 at 2.5%.

“Israel’s risk premium went up … we want first and foremost to ensure that the financial systems are working,” Yaron said. “We want to stabilize the financial side because certainly if there are problems there, there will be even bigger problems on the real (economy) side.”

Rather than cut rates, Yaron said the central bank was taking steps that act like monetary easing, such as working with banks to allow those impacted by the conflict to defer or freeze loan repayments.

“Only when we get to recovery (after the war) can we think what do on the interest rate side,” he said. “For now, uncertainty is very high.”

GROWTH ESTIMATE

The bank’s staff believe the key interest rate will drop to between 4.0% and 4.25% in the coming year.

As a consequence of the war that began on Oct. 7 after Hamas attacked Israeli towns in the worst assault on civilians in the country’s history, the bank trimmed Israel’s growth estimate for 2023 to 2.3% from 3.0% and to 2.8% next year from a prior 3.0%.

The forecasts are based on the conflict being concentrated in the south on the Gaza border in the fourth quarter, but a longer or shorter timespan – and developments in the war that would expand to Hezbollah on the Lebanese border or other areas – would change the estimates substantially, Yaron said.

“We have known how to recover from difficult periods in the past and to return rapidly to prosperity. I have no doubt that it will do so this time as well,” he said.

The central bank is also working to keep the shekel contained by selling $30 billion of foreign currency. With no rate move widely expected, the shekel was steady against the dollar at a 4.06 rate, its weakest level since March 2020.

Since the start of the war, the shekel has shed 5% and is down 15.5% in 2023.

Government officials have said they will spend what they need on the war and on compensation for those impacted, but Yaron cautioned of the need for some fiscal restraint. The central bank projects the debt to GDP ratio growing to 62% this year and to 65% in 2024 from 60.5% in 2022.

“It is important to continue conducting responsible fiscal policy, and to convey this to the markets, which today more than ever are following the activity in Israel,” Yaron said, adding less crucial expenses should be cut.

Fitch last week put Israel’s credit ratings on credit watch negative while Moody’s (NYSE:) put its ratings on review for a possible downgrade.