The evolving conflicts in the Middle East since October 2023 will continue to shape economic activity. GDP growth is projected to be 2.4% in 2025 and 4.6% in 2026. Military expenditure keeps government demand high. Partial normalisation in the business environment is assumed to allow a pick-up in exports and private consumption from mid-2025. Labour shortages are constraining construction and fuelling price pressures. Risks loom large: an intensification of the conflicts would further weigh on activity and an already large fiscal deficit. On the other hand, a swift de-escalation could unleash pent-up demand.

Fiscal policy should take action to steadily reduce the deficit in coming years. Revenue increases are needed to fund permanently higher defence expenditures while focussing spending on key areas, including research, education, and public investment. Monetary policy needs to remain restrictive to ensure inflation returns to the target range. Large arrivals of foreign workers and the reopening of work permits for Palestinians would reduce labour shortages.

Economic conditions are deeply impacted by the conflicts. The sharp increase in military activities has prompted government demand to rise by more than a fifth from its pre-war level in the second half of 2024. After a fast recovery from the slump in the aftermath of 7 October 2023, private consumption has grown sluggishly, with consumer confidence remaining weak in October 2024. Business confidence by contrast has been stronger, with respondents overall moderately optimistic, and local stock markets have recovered fully. Persistent labour shortages in construction have constrained investment. Few new foreign workers (0.4% of employment) have entered Israel since work permits were suspended for Palestinians (4% of employment before the war). Rocket attacks have significantly reduced industrial and farm production in Northern areas. Supply constraints contributed to inflation picking up from 2.5% to 3.5% over February-October 2024.

The conflicts have been impacting foreign trade. Ship attacks in the Red Sea have made shipping more expensive, while reduced airline connections complicate services trade. Intensifying tensions since mid-2024 have hurt the high-tech sector, halting the rally in high-tech shares. Inward foreign tourism remains nearly absent.

After a strong impulse as the budget balance moved from surplus in 2022 to an estimated 7.5% of GDP deficit in 2024, fiscal policy is set to tighten in 2025-26 by over 2% of GDP. The deterioration in public accounts led all three major credit rating agencies to downgrade Israel’s government credit rating. Despite continued elevated military spending in 2025, the authorities are reducing the deficit by raising taxes and curbing civilian expenditure. Tax increases combine permanent measures, such a one percentage point increase in the main VAT rate, with changes that may be more challenging to maintain, such as freezes in income-tax thresholds. Defence spending is expected to decrease from mid-2025 albeit remaining at a higher share of GDP than before the war. The central bank is projected to keep policy interest rates on hold at 4.5% through the projection period. The fiscal drag and a gradual improvement in supply conditions from mid-2025 are projected to offset the price pressures that have been building since early 2024.

Growth is projected to pick up to 2.4% in 2025 and 4.6% in 2026 with the composition of demand changing over time. Export growth is anticipated to gain pace gradually, particularly from the latter half of 2025, including in high-tech services. Private consumption should follow a similar path. Government consumption will turn from supportive to restrictive over time. Investment remains constrained by labour shortages, in particular for construction. Inflation is projected to rise in 2025 to 3.6% including under the effect of the VAT increase before moderating to 2.9% in 2026 as supply constraints ease.

Risks are very large. On the downside, a renewed intensification of the conflicts could substantially degrade public accounts while directly reducing activity. Loss of foreign-investor confidence could result in further increases in government bond yields and test the value of the currency. On the upside, an acceleration of the de-escalation could unleash pent-up foreign and domestic private demand prompting a much-faster-than-projected upturn and improvement in the fiscal accounts.

Monetary policy needs to remain prudent. With inflation expectations close to the top of the 1-3% target range, further rate increases would become necessary if delivery of fiscal-consolidation plans is limited or price pressures build up more strongly than projected. The government should favour permanent fiscal reforms, such as removing VAT exemptions, and reducing subsidies that encourage staying outside the labour market, over measures that are more likely to be reversed, such as tax-bracket or allowance-level freezes. Ending the suspension of Palestinians’ work permits would tackle labour shortages in construction. Removing subsidies that discourage work among ultra-Orthodox men while ensuring that all pupils learn the core curriculum would broaden employment and improve labour productivity. Higher carbon pricing would accelerate decarbonisation.