The cost of war is permeating every aspect of Israel's national finances. The Israeli Knesset passed the 2026 national budget in the early hours of Monday, totaling 699 billion shekels (approximately $222 billion), with the Fiscal Deficit target set at 4.9% of GDP and defense spending surging over 120% compared to before the outbreak of the Gaza conflict in 2023. The budget gap will primarily be filled through borrowing and cuts to civilian spending.
The Bank of Israel is expected to maintain its benchmark interest rate at 4% for the second consecutive time on Monday and will release its first updated macroeconomic forecast since the outbreak of the Iran-Israel conflict. Central bank governor Amir Yaron has already issued an early warning that the upward revision of the deficit target combined with the downward revision of growth forecasts will jointly push up Israel's debt-to-GDP ratio. Fitch Ratings, while maintaining Israel's sovereign rating at 'A', revised the outlook to negative and expects the actual deficit this year to further expand 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 plummeted 3.8% last Friday, marking its largest single-day drop in nearly a year and erasing all gains since the outbreak of the Iran-Israel conflict in late February. Currently, Israel is simultaneously dealing with a direct confrontation with Iran and military operations in Lebanon against Hezbollah militants, as the front lines continue to extend.
Over the weekend, the Houthi rebels in Yemen announced their alignment with Iran and launched missiles toward Israel, opening a new front. This further increased the risk premium in the crude oil market and caused domestic inflation expectations in Israel to heat up again, placing the central bank's monetary policy in a dilemma.
<h2>Defense Spending Surges, Deficit Expansion Funded by Borrowing</h2>
Israel's parliament (Knesset) passed the 2026 national budget with a vote of 62 to 55 in the early hours of Monday. Defense spending is the largest single item in the budget, amounting to 143 billion shekels, an increase of approximately 120% compared to before the Gaza war began in 2023. The government has also set aside a special reserve of 6 billion shekels for expenses related to the war with Iran or other military needs, bringing the total supplementary defense budget to at least 38 billion shekels (about $12.4 billion), representing approximately 2% of GDP. These funds are primarily used to replenish Israel's military inventory and pay the salaries of reservist soldiers.
The deficit target was previously expected to be 5.1% of GDP but was ultimately narrowed to 4.9% because Israeli banks agreed to a one-time tax payment of approximately 3 billion shekels to the treasury. Other sources of funding include 10 billion shekels in government revenue exceeding budget targets and a uniform 3% spending cut across all civilian government departments. Since Israel launched its military retaliation against Hamas militants in October 2023, the scale of government borrowing has expanded sharply, with a 2024 peak approaching 280 billion shekels.
Israeli Prime Minister Netanyahu stated in a video message last week: &#34;This war is very expensive, so we need a special budget, including tens of billions of shekels to strengthen defense spending.&#34;
<h2>Political Compromises Pave the Way for Budget Approval</h2>
The smooth passage of the budget was partly due to a series of political concessions made by Netanyahu to consolidate consensus within the coalition government. He shelved several bills that had caused friction within the ruling coalition, including a highly controversial bill intended to exempt ultra-Orthodox men from mandatory military service. Finance Minister Bezalel Smotrich abandoned his previously championed proposal for a national dairy regulatory reform, which was originally aimed at easing the public's cost-of-living pressures. Smotrich stated alongside Netanyahu last week: &#34;In times of war, we need unity and national responsibility.&#34;
The approval of the budget holds special political significance for Netanyahu's cabinet—according to Israeli law, if a budget is not approved by March 31, the government will automatically dissolve.
The budget legislation package also includes several tax incentives: tax exemptions for returning overseas Israelis and Jewish immigrants to address the brain drain caused by the war; tax benefits for middle-class employees; and corporate tax reductions for the research and development activities of technology companies.
<h2>Growth Forecasts Revised Downward, Debt Pressure Continues to Rise</h2>
According to a Bloomberg survey of economists, all respondents predict that the Bank of Israel will maintain its benchmark interest rate 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 hosted by Governor Amir Yaron.
Regarding economic growth, institutional forecasts are consistent in being significantly lower than pre-war expectations. Yaron told reporters last week that before the current conflict, the central bank expected this year's Economic Growth Rate to be 5.2% with a Fiscal Deficit target of 3.9% of GDP, &#34;a level that could have stabilized our debt-to-GDP ratio.&#34; Now, the higher deficit and lower growth will lead to a higher debt ratio. Rafael Gozlan, Chief Economist at IBI Investment House, currently forecasts a growth rate of about 4% for 2026, with downside risks; Bank Hapoalim, Israel's second-largest bank, expects economic expansion to be only 3% if the war ends by the end of the month.
Fitch Ratings, while maintaining Israel's sovereign rating at 'A', revised the outlook to negative and expects the Fiscal Deficit to widen from 4.7% of GDP in 2025 to 5.7% this year, exceeding the government's 4.9% target, mainly because actual military spending is expected to be higher than government forecasts.
<h2>Inflation Rises, Monetary Policy Faces Dilemma</h2>
The extension of the war fronts has also created a dilemma for the Bank of Israel's monetary policy. Israel's reliance on domestic natural gas production has partially offset some of the impact of soaring global oil prices, but local analysts have begun to raise price expectations. Bank Hapoalim raised its inflation forecast for the next 12 months to 2.2%, higher than the median of the central bank's 1% to 3% target range, citing persistent upward pressure on airfare and the potential for new taxes to drive up inflation. &#34;A prolonged war could lead to further increases in inflation,&#34; the bank's economists wrote in a report to investors. &#34;Meanwhile, as most major central banks have entered a rate-hiking cycle, it is unlikely that the Bank of Israel will move against the trend.&#34;
Regarding interest rate path predictions, some analysts expect a 25-basis-point rate cut within the next year, but Bank Hapoalim believes the benchmark rate could eventually fall to 3.5%. The bank pointed out: &#34;Once the war ends, output contraction and the expected decline in oil prices will jointly bring rate cuts back to the agenda sooner than currently priced in by the market.&#34;

ISRA

The Israeli Knesset on Monday passed the 2026 budget totaling 699 billion shekels, with defense spending surging over 120% compared to pre-war levels. Impacted by multi-front conflicts, the government raised the Fiscal Deficit target to 4.9% of GDP, leading to mounting debt pressure, a negative outlook for sovereign ratings, and a sharp decline in the stock market. The central bank is expected to maintain interest rates at 4%, balancing the dilemma between rising inflation and downward revisions to the Economic Growth Rate

- Israel's national budget for 2026, totaling 699 billion shekels (approximately $222 billion), was approved by parliament, with a deficit target of 4.9% of GDP, primarily driven by a 120% surge in defense spending amidst ongoing conflicts.  
- The central bank is expected to maintain the benchmark interest rate at 4% and has revised down the economic growth forecast, projecting a rise in the debt-to-GDP ratio due to larger-than-expected military expenditures.  
- Additionally, the budget includes tax incentives to mitigate economic impacts from the war, reflecting the government's need for political unity and financial stability during this crisis.

War Weighs on Economy: Israel Significantly Lowers Growth Forecast, Defense Spending Doubles, Fiscal Deficit Target Rises to 4.9%