Labour councillor Obaida Ahmed led a crowd in chants of "from the river to the sea... Palestine will be free" at a protest in Wolverhampton city centre on May 15.
The chant is widely used by campaigners, some of whom advocate the abolishment of Israel, and is also a rallying cry used by Palestinian militant group Hamas.
However, Councillor Ahmed says she believes in the right of Israel to exist and used the slogan "in the context of the need for a peaceful resolution to the conflict and as a call to end the occupation in Palestine".
The event, which took place in front of the statue of Prince Albert and was organised by Wolverhampton Palestine Solidarity Campaign, also featured a speaker who compared Israel with the Nazis.
Lord Austin said St Peter's ward councillor Ms Ahmed's behaviour was "completely unacceptable", while the Campaign Against Antisemitism said it was evidence that the Labour Party had failed to address issues of racism.
Marie van der Zyl, Jewish Board of Deputies president, said Councillor Ahmed's chant was taken to mean "the destruction of Israel in its entirely".
Speaking into a megaphone at the rally, Councillor Ahmed, who was appointed to Wolverhampton Council's ruling cabinet last month, told the crowd: "I make this plea to all of you.
"Please continue to raise issues in your circles, continue to attend protests like this, and continue to stand for justice each and every day and each and every way we can.
"So let me hear you... from the river to the sea...", to which the crowd responded: "Palestine will be free", followed by chants of "free, free, Palestine".
Footage on social media shows another speaker telling the crowd: "What the Zionists are doing to Palestine is no different to what Hitler did in Germany. They are Nazis, they are killing the children."
Also present at the rally was Councillor Ahmed's fellow St Peter's councillor Qaiser Azeem, the ward secretary.
Sir Keir Starmer vowed to get to grips with anti-Semitism in the Labour Party after he succeeded Jeremy Corbyn in April. Months later he apologised to Jewish people "for all the pain and grief that has been caused" following the publication of a damning report by the Equality and Human Rights Commission.
Lord Austin, who quit Labour as an MP over its failure to deal with anti-Semitism under Mr Corbyn, said the Wolverhampton rally showed "the scale of the problem Labour faces".
He said: "It is completely unacceptable for a Labour councillor to chant 'from the river to the sea, Palestine will be free’ which means Israel should be abolished, and it is an absolute disgrace that a demonstration was held on the streets of the Black Country where people compared Israel with the Nazis who murdered millions of Jewish people."
A spokesperson for Campaign Against Antisemitism said: “It is extraordinary that politicians and organisations continue to participate in and sponsor rallies that persistently feature anti-Semitic tropes.
"Despite being declared institutionally racist against Jews just six months ago by the EHRC, and notwithstanding the current special measures imposed on the party to address its unlawful anti-Semitism, Labour officeholders appear to have learned nothing.
"Too many have joined anti-Semitic chants or encouraged, attended and addressed rallies featuring anti-Semitic banners and chants, contributing to the atmosphere conducive to the rampant anti-Semitism, physical assaults on Jews and damage to Jewish property that we have seen in recent weeks.
"Labour has managed to return to square one when it comes to anti-Semitism.”
Councillor Ahmed said: "I believe in the fundamental right of Israel to exist and for its people to be able to live in peace and security. I also believe the Palestinian people have the right to live in peace and security.
"I used the slogan in the context of the need for a peaceful resolution to the conflict and as a call to end the occupation in Palestine. I understand that for some people it has another meaning and I will be mindful and respectful of this in the future.
“If we have learned only one thing from the decades of bloodshed and hurt in the Middle East it is that no one will be safe until everyone is safe.”