War weighs down the economy: Israel sharply lowers growth forecast, doubles defense spending, raises fiscal deficit target to 4.9%.

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The cost of war is permeating every aspect of Israel’s national finances. Early Monday morning, the Israeli parliament passed the 2026 national budget, totaling 699 billion shekels (about $222 billion USD), with a fiscal deficit target set at 4.9% of GDP. Defense spending has surged more than 120% compared to pre-2023 Gaza conflict, and the budget gap will be mainly covered by borrowing and cuts in civilian spending.

The Bank of Israel is expected to keep its benchmark interest rate unchanged at 4% for the second consecutive time on Monday, and will release its first updated macroeconomic forecast since the outbreak of the Israel-Iran conflict. Bank Governor Amir Yaron has already warned that the increased deficit target combined with lower growth forecasts will collectively push up Israel’s debt-to-GDP ratio; Fitch Ratings, while maintaining Israel’s sovereign rating at ‘A’, revised its outlook to negative and expects the actual deficit to widen this year to 5.7% of GDP, exceeding the government’s target.

Israeli assets have already come under pressure. According to Bloomberg, the Tel Aviv 35 Index plunged 3.8% last Friday, marking its largest single-day drop in nearly a year, erasing all gains since the Israel-Iran conflict erupted at the end of February. Currently, Israel is simultaneously dealing with direct conflict with Iran and military operations against Hezbollah forces in Lebanon, with battle lines extending.

Over the weekend, Yemen’s Houthi militants announced they were joining Iran’s side, launching missiles at Israel, opening a new front and further raising risk premiums in the crude oil market. This has also heated up domestic inflation expectations in Israel, putting the central bank’s monetary policy in a dilemma.

Defense Spending Soars, Deficit Expansion Covered by Borrowing

The Israeli parliament (Knesset) passed the 2026 national budget early Monday by a vote of 62 to 55. Defense spending is the largest single item in the budget, at 143 billion shekels—an increase of about 120% compared to pre-2023 Gaza war levels. The government has also set aside a special 6 billion shekel reserve fund for Iran-related war expenses and other military needs, bringing total supplemental defense spending to at least 38 billion shekels (about $12.4 billion USD), roughly 2% of GDP. These funds are mainly for replenishing Israel’s military stockpiles and paying reservist salaries.

The deficit target was previously projected at 5.1% of GDP, but thanks to Israeli banks agreeing to pay around 3 billion shekels in one-time taxes to the treasury, it was narrowed to 4.9%. Other sources of funding include: government revenues exceeding budget targets by 10 billion shekels, and unified budget cuts of 3% for all civilian government departments. Since Israel began its military retaliation against Hamas in October 2023, government borrowing has expanded drastically, peaking at nearly 280 billion shekels in 2024.

Israeli Prime Minister Netanyahu stated in a video address last week: “This war is extremely expensive, so we need a special budget, which includes tens of billions of shekels to boost defense spending.”

Political Compromise Paved the Way for Budget Approval

The smooth passage of this budget was partly due to a series of political concessions made by Netanyahu to achieve consensus within the coalition. He shelved several bills that had caused friction within the governing alliance, including a highly controversial bill to exempt ultra-Orthodox men from mandatory military service. Finance Minister Bezalel Smotrich dropped a previously pushed dairy industry reform bill—which was originally intended to ease cost-of-living pressures on the public. Smotrich stated last week alongside Netanyahu: “Times of war call for unity and national responsibility.”

For Netanyahu’s cabinet, the approved budget carries special political significance—according to Israeli law, if the budget is not passed by March 31, the government will automatically dissolve.

This budget package also includes several tax incentive measures: tax exemptions for returning overseas Israelis and Jewish immigrants to address war-induced talent outflow; tax benefits for middle-class employees; and corporate tax reductions for technology company research and development activities.

Growth Forecasts Slashed, Debt Pressure on the Rise

According to a Bloomberg survey of economists, all respondents expect the Bank of Israel to keep its benchmark interest rate unchanged at 4%. The central bank will simultaneously release its first updated macroeconomic forecast since the conflict broke out on February 28, followed by a press conference by Governor Amir Yaron.

In terms of economic growth, all agencies’ forecasts are sharply revised down from pre-war levels. Yaron stated to reporters last week that before the current conflict, the central bank expected GDP growth of 5.2% and a fiscal deficit target of 3.9%, “which could have stabilized our debt-to-GDP ratio,” but now, with a raised deficit and a revised-down growth rate, that ratio will climb. Rafael Gozlan, chief economist at IBI Investment House, currently forecasts approximately 4% growth in 2026, with downside risk; Israel’s second-largest bank, Bank Hapoalim, expects that if the war ends this month, expansion will only reach 3%.

Fitch Ratings, while keeping Israel’s sovereign rating at ‘A’, revised its outlook to negative and expects the fiscal deficit to widen from 4.7% of GDP in 2025 to 5.7% in 2026, exceeding the government’s 4.9% target—mainly because actual military spending is likely to be higher than government forecasts.

Inflation Heats Up, Monetary Policy Dilemma

Extending battle lines has also created a dilemma for the Bank of Israel’s monetary policy. Israel relies on domestic natural gas production, partially offsetting the impact of surging global oil prices, but local analysts have begun raising price forecasts. Bank Hapoalim increased its 12-month inflation forecast to 2.2%, above the central bank’s mid-range target of 1%-3%, citing persistent airfare inflation and the potential for new taxes to push up prices. “Prolonged war could drive inflation further up,” the bank’s economists wrote in a report to investors, “and meanwhile, most major central banks are in rate-hiking mode. Israel’s central bank is unlikely to go against the trend.”

On the rate path, some analysts expect a single 25-basis-point rate cut next year, but Bank Hapoalim believes the benchmark rate could ultimately fall to 3.5%. The bank noted: “Once the war ends, shrinking output and anticipated declines in oil prices will jointly bring rate cuts back on the agenda sooner than the market currently expects.”

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