While the shock originating in the Middle East is pushing many economies worldwide toward higher inflation, higher interest rates and weaker growth, in Israel the macroeconomic picture is moving in the opposite direction — annual inflation has fallen to its lowest level in roughly five years, the shekel remains very strong, the risk premium has returned to the range that characterized it before the “Swords of Iron” war, the labor market remains tight at around full employment, and the policy rate has resumed its descent.
In the last column I published here, I assessed that the strong shekel, alongside the distinctive structure of Israel’s energy sector, would help contain the inflationary pressures arriving from abroad and allow the Bank of Israel to continue its rate-cutting cycle. Developments since then have reinforced that assessment — inflation continued to moderate, and in July the Bank of Israel cut the rate by 25 bps, to 3.50%. The Bank’s own forecast now embeds a continuation of the process, with an average rate of 3.0% in the second quarter of 2027 — that is, two further cuts over the coming year.
The strong shekel is not merely an expression of relative confidence in the Israeli economy; it is also an important economic factor in its own right. In a world where energy and commodity prices are once again being driven by the war in the Middle East, the appreciation of the domestic currency offsets part of the rise in import prices. In other words, some of the inflationary pressures arriving from abroad are absorbed by the exchange rate before they reach the Israeli consumer. The Bank of Israel likewise notes that the shekel’s appreciation supports the moderation of the inflation environment.
Having mentioned USD/ILS, in recent months the Bank of Israel has also returned to purchasing foreign currency. In May it bought roughly USD 801 million, and in June roughly USD 1.03 billion. Relative to the large-scale purchase programs seen in the past, these are not dramatic volumes, and the Bank stresses that the purchases were made on a discretionary, ad hoc basis to preserve orderly market functioning. Even so, the mere return to the market is a reminder that the Bank has both the tools and the willingness to act when volatility turns abnormal.
Back to the rate decision: one of the things that stood out in the latest statement was the shift in tone on inflation risks. In previous statements the Bank emphasized that risks were tilted to the upside. This time it noted that there are factors liable to affect inflation in opposing directions. This may sound like a minor semantic change, but in central-bank language it carries a meaningful message — the balance of inflation risks has become more even.
The economic forecasts improved as well. The Bank of Israel raised its 2026 growth forecast from 3.8% to 4.0% and, at the same time, lowered its inflation forecast from 2.2% to 1.8%. Beyond the headline figure, the composition of the forecast is also constructive — exports excluding diamonds and startups are projected to grow 8% in 2026, as is fixed-asset investment. These are the components capable of supporting a recovery that does not rest solely on government consumption or on a technical rebound after the war.
On the real side, too, the picture improved. The first quarter was admittedly hit by the confrontation with Iran, but the high-frequency indicators point to a recovery in activity through the second quarter. For example, the monthly State-of-the-Economy Index (Bank of Israel) rose 0.6% in June, following gains of 0.8% and 6.2% in May and April, respectively. With that, the index returned to a higher level than before “Rising Lion,” indicating that the negative output gap is narrowing.
The labor market remains tight, with unemployment around 3.0% and the number of job vacancies rising to 146 thousand — here too a high level relative to the period before “Rising Lion.” A further indication of continued economic recovery comes from tax revenues, which came in higher than expected in the first half of the year, leading the Bank of Israel to lower its 2026 deficit forecast from 5.3% to 4.9% of GDP. In June, the trailing 12-month deficit recorded a further decline, to 3.3% of GDP — so here, too, we are seeing upside surprises.
So much for the positives. On the less favorable side, Israel is of course not immune to the war, and it still contends with a heavy security and fiscal cost. The 2026 deficit ceiling stands at 4.9%, and the debt-to-GDP ratio is expected to rise to 69%. For now, the deficit appears to be surprising favorably from month to month, partly on the back of revenue growth beyond expectations. That said, looking ahead, should we see a further increase in the defense budget, this could be perceived as less favorable in the eyes of investors — and even of the Bank of Israel.
As things stand, the data point to an economy under control. Anyone who views Israel solely through the security headlines is liable to miss a flexible, technology-intensive economy with credible economic institutions, a strong labor market and a financial system that continues to function even under stress. Bottom line: Israel is still in the eye of the storm, but it is entering the next phase from a far stronger position than it appears from the outside.
Matan Shitrit is Chief Economist at Phoenix Financial
Source:
www.jpost.com
