Israeli economy unexpectedly contracts 3.3% due to military operations
Hopes for a quick recovery were dashed: private consumption plunged 4.6%, and exports fell nearly 4%. The Bank of Israel is now torn between supporting a faltering economy and still-high geopolitical risks.
3.3%. The Israeli economy collapsed in the first quarter of 2026 — and this is not a forecast, but a fact recorded by the Central Bureau of Statistics on Sunday, May 17. The consensus forecast of seven economists surveyed by Bloomberg had predicted a decline of 2%. The Ministry of Finance had estimated an annualized drop of 9.5%. Reality turned out worse than the consensus but better than the worst nightmares — and that doesn't make it any easier.
Private consumption fell 4.7%. Exports dropped 3.7%. Business activity contracted 3.1%, compared to growth of 5.4% in the previous quarter. Hopes for a quick V-shaped recovery after the ceasefire on April 8 were shattered by the numbers.
A month and a half of paralysis
The war with Iran lasted from February 28 to April 8 — just over a month. But that was enough to put the economy on hold. The mass call-up of reservists pulled hundreds of thousands of people from their jobs. Most Israelis simply stayed home. Business closures for security reasons lasted more than a month.
Credit card data shows an instant 20% drop at the start of hostilities — almost the same as during the previous campaign against Iran. A partial recovery began after two weeks, but consumption never returned to pre-conflict levels.
March was the first full month of the war — and foreign trade data collapsed. Imports fell 12% month-on-month: consumer goods down 16%, raw materials down 10%, investment goods down 22%. This partly reflects a temporary weakness in economic activity, and partly technical constraints at customs.
Bank of Israel between inflation and recession
The Bank of Israel has kept the key interest rate at 4% since late March — and is in no hurry to cut. The reason is simple: inflation. The war drove up energy prices worldwide, and Israel is no exception. The central bank estimates inflation this year at 2.2%, up from a January forecast of 1.7%. In March, the regulator warned it could reach the upper bound of the target range at 3%.
Bank of Israel Governor Amir Yaron finds himself in a typical central banker's trap. On one hand, a faltering economy that needs cheap money. On the other, a budget deficit of 5.3% of GDP, which itself fuels inflation and ties the hands of monetary authorities.
Israel's real interest rate is currently 1.7% — the highest among all developed economies. In the US and UK, this indicator hovers around 0.5%; in the eurozone and Japan, it is negative. The shekel is strengthening, attracting foreign capital, which is good for curbing inflation but devastating for exports.
The Bank of Israel's forecast assumes one or two rate cuts by the end of 2026 — to 3.5% or 3.75%. But this will only happen under a baseline scenario: the war ends, inflation slows, and supply constraints ease.
Budget drama behind the scenes
While the central bank holds rates, the government is inflating the deficit. The Knesset approved the 2026 budget with a deficit of 4.9% of GDP. Plus 800 million shekels for the Haredi education system, pushed through by a parliamentary maneuver.
Amir Yaron admitted in an interview with Globes: "We had little influence on the final adjustments." The Bank of Israel had insisted on a deficit just above 3%. The government started at 3.6%, ended at 4.9%, and the central bank estimates the actual figure at 5.3% due to a revised growth forecast.
The growth forecast for 2026 has been cut from 5.2% to 3.8%. The forecast for 2027, on the other hand, has been raised to 5.5% — expectations of a rapid recovery after the end of hostilities are still alive. The question is how realistic they are.
Housing, loans, and a tectonic shift in consumption
High interest rates hit the real estate market. Mortgage lending is shrinking, and developers are trying to bypass expensive loans with special financing programs. The government is pushing a law to subsidize mortgages — instead of simply cutting rates, as Meitav's chief economist Alex Zabezhinsky wryly notes.
Long-term rates, on which mortgages depend, remain high. This slows both construction and consumption. Households are saving rather than spending, which delays recovery.
In the first quarter, a rare positive signal was recorded: investments rose 12.6%. But this is likely statistical noise or delayed projects, not a sustainable trend — against the backdrop of falling consumption and exports, investment growth looks anomalous.
Who loses, who waits
Exporters suffer from a strong shekel. The real interest rate attracts foreign capital, the currency strengthens, and Israeli goods lose competitiveness. The trade deficit in the first quarter reached $46.7 billion on an annualized basis — significantly higher than $40 billion in 2025.
The labor market remains tight. Wage growth in the business sector accelerated to 4.7% over November-January. This supports consumption but also fuels inflation and complicates life for the central bank.
The tech sector, traditionally the engine of the Israeli economy, is holding up for now. But if the rate stays at 4% until the end of the year, venture funding will begin to shrink — investors will prefer risk-free bonds with guaranteed returns.
What's next
The baseline scenario is a cautious rate cut in the second half of the year. One or two moves of 25 basis points each. Growth will return to 3.8% for the year, as the Bank of Israel forecasts.
But this scenario depends on three conditions: the ceasefire holds, inflation does not accelerate, and energy prices do not spike again. One incident — an attack on Iranian oil facilities or a new blockade of the Strait of Hormuz — and the forecast goes out the window.
The Israeli economy survived 2023 with the war in Gaza, survived 2025 with a twelve-day campaign against Iran. Now it is adapting to a new normal — high rates, chronic deficits, and military spending that won't go away. As Amir Yaron says, "We hope to get on a normalization trajectory by 2027." But between hope and reality lies another year and a half of geopolitical uncertainty.
— Editorial Team
