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Abstract
Monetary policy: The first half of the year featured continued geopolitical uncertainty. Annual inflation declined, in contrast with the global trend, and stabilized around the midpoint of the target range, and the unemployment rate remained low except for a temporary increase during Operation Roaring Lion (the military confrontation with Iran that began on February 28, 2026). Against this background, and considering the high level of uncertainty, the Monetary Committee lowered the interest rate gradually during the first half of the year. In the January, May, and July 2026 decisions, the Committee reduced the interest rate by 0.25 percentage points in each of the decisions, so that the interest rate at the end of the reviewed period was 3.5 percent.
At the beginning of the period, the Monetary Committee’s assessment was that the risks to inflation tended upward. During the half-year, partly in view of the increased appreciation of the shekel, the downward risks to inflation also increased. At the beginning of June, the Governor clarified that as long as inflation expectations continue to decline, and particularly if they draw near to the lower bound of the target range, it would justify a more accommodative monetary policy and a more rapid pace. In its decisions, the Committee noted that the interest rate path would be determined in accordance with the development of inflation, economic activity, geopolitical uncertainty, and fiscal developments. Therefore, the Monetary Committee would continue acting in accordance with the data and with assessments of the most recent economic developments.
The inflation environment: Throughout the period reviewed, the inflation rate hovered around the midpoint of the inflation target range, after converging to within the target range in the previous half-year. At the end of the first half of 2026, annual inflation was 1.9 percent, near the midpoint of the target (based on the May CPI reading), compared with 2.4 percent at the end of the second half of 2025 (based on the CPI reading for November 2025), and 3.1 percent at the end of the first half of 2025 (based on the CPI reading for May 2025). One-year inflation expectations from all sources were around the midpoint of the target range throughout the half-year, and they declined toward the end of the period. Longer-term expectations hovered around the midpoint of the target range. The inflation environment was impacted by the fact that the shekel strengthened markedly, among other things.
Real activity in Israel: National Accounts data for the first quarter of 2026 reflected the impact of Operation Roaring Lion on economic activity. In the first quarter of the year, GDP contracted by an annual rate of 3.8 percent, while business sector output also declined by 3.8 percent (seasonally adjusted in annual terms). This contraction was more moderate than in earlier forecasts and relative to Operation Rising Lion (the military confrontation with Iran in June 2025).
Against the background of the decline in growth in the first quarter, the gap between the level of GDP and its long-term trend widened to about 4.6 percent. However, indicators for growth in the second quarter of 2026 pointed to expectations of a significant narrowing of this gap.
The contraction in GDP in the first quarter of 2026 was driven primarily by declines in private and public consumption, while exports increased. At the same time, civilian imports rose significantly—a development consistent with the assessment that supply constraints in the domestic market continued to weigh on the level of activity during the half-year.
Analyses conducted by the Research Department indicate that a substantial share of economic growth in the recent period reflected production abroad by global firms operating in Israel. Excluding the activity of these firms, growth was lower, given the prevailing supply constraints. As these constraints ease, growth is expected to become broader-based across a wider range of industries and firms, while GDP converges toward its long-term trend.
The labor market: During the half-year, the labor market remained tight—unemployment was low and wages increased at a rapid pace. The labor market was affected significantly, though temporarily, by Operation Roaring Lion. The rate of those temporarily absent from work due to reserve military service rose sharply in March, but declined significantly in April and May, reaching a relatively low rate of 0.5 percent in May. The broad unemployment rate among those aged 25–64 declined in May to a low level of 3 percent. The job vacancy rate increased slightly, though it remained below its level from prior to Operation Roaring Lion. The employment rate and the labor force participation rate among those aged 15 and over declined in May, similar to recent months. Among the core working-age population, aged 25–64, the employment rate and the participation rate remained stable in May.
The rate of wage growth in the economy in March–May was 6.8 percent relative to the corresponding period of the previous year. The increase in wages partly reflected changes in the composition of workers due Operation Roaring Lion, an increase in the minimum wage, and a public sector wage increment that took effect in April under the framework agreement.
The exchange rate, the risk premium, and the financial markets: During the reviewed half-year, trading in the financial markets remained volatile, influenced by both domestic and global uncertainty. Since January 2026, the shekel appreciated by about 10 percent against the US dollar, reaching NIS 2.8 per dollar at the end of May. In June, however, the shekel depreciated, such that by the end of the period, the exchange rate stood at about NIS 3.0 per dollar.
The appreciation over the past two years was influenced to a large extent by three factors: geopolitical developments and the decline in Israel’s risk premium, gains in US equity markets, and the weakening of the US dollar globally. The Bank of Israel purchased foreign exchange totaling $801 million in May and $1,027 million in June. These purchases were made on a specific basis in order to preserve the continued orderly functioning of the markets.
Israel’s risk premium—as measured by CDS spreads and the spreads on US dollar-denominated government bonds—continued to decline after rising at the beginning of Operation Roaring Lion, and remained in an environment similar to its level prior to October 7. Domestic equity indices outperformed global markets during most of the period under review. However, since the announcement of the memorandum of understanding between the United States and Iran in June, they have underperformed relative to global markets.
Credit to the business sector continued to expand at a rapid pace during the reviewed period, led by bank credit. This expansion was evident across all industries—with an emphasis on the financial services and construction industries—and across all business size groups, with the exception of small and micro businesses. Payments in arrears in all activity segments remained low. The banking system continued to maintain high capital ratios, and insurance companies continued to maintain high solvency positions.
Fiscal policy: The cumulative deficit in the state budget over the previous 12 months declined during the reviewed half-year, to 3.8 percent of GDP in May, compared with 4.7 percent of GDP in December. This was mainly due to a low level of government expenditure in view of the interim budget in the first quarter of the year. Government revenues from direct taxes (at fixed prices and net of legislative changes and one-off revenues) remained above the long-term trend line.
The housing market: The level of activity in the construction industry remained high. Housing starts, housing completions, and building permits remained at high levels. These developments, together with some decline in the volume of transactions relative to 2024, led to an increase in contractors’ inventory of unsold homes and to a decline in home prices totaling 1.3 percent in annual terms.
The annual rate of increase in the owner-occupied housing services component (rent in new and renewing contracts) of the Consumer Price Index stood at 4 percent at the end of the half-year (May data), compared with 2.6 percent and 3.6 percent at the end of the previous half-years (November and May 2025 data, respectively). In May, new mortgage borrowing totaled about NIS 9.5 billion (seasonally adjusted).
The global economy: During the reviewed half-year, global economic activity expanded at a moderate pace. Despite the high geopolitical uncertainty resulting from the confrontation between the United States and Iran, the disruption to supply chains, and the increase in commodity prices, growth remained positive in most of the major blocs during the period.
Energy prices were highly volatile, and were influenced to a large extent by geopolitical developments—Brent crude oil, which stood at $60 per barrel at the beginning of the period, rose to $120 during the half-year and declined to about $70 by its end. The global Purchasing Managers’ Index remained throughout the period at a level indicating continued expansion in global output, similar to the previous half-year.
In April, the International Monetary Fund (IMF) revised its global growth forecast downward and its forecast for global inflation upward, with the main effect on the forecast coming from the shock in energy markets and the high level of uncertainty. In the United States, GDP grew in the first quarter at an annual rate of about 2 percent, significantly higher than in the previous quarter. Employment reports during the half-year were mostly strong and, on balance, pointed to a tight labor market. In the eurozone, the data for the first quarter of 2026 pointed to a slowdown in the pace of growth, with GDP increasing by only 0.1 percent in quarterly terms, below market expectations.
Annual inflation in the United States accelerated, and the Consumer Price Index (CPI) for May stood at 4.2 percent, compared with 2.7 percent at the end of the previous half-year. Annual inflation in the eurozone also accelerated, reaching 3.2 percent in May, compared with 2.1 percent at the end of the previous half-year.
During the reviewed period under review, the ECB raised its policy rate in June, while the Fed left its policy rate unchanged. Since the beginning of the confrontation with Iran, the market-implied interest rate path of many central banks has risen significantly.
The Research Department forecast: According to the Research Department’s July 2026 staff forecast, GDP is expected to grow by 4 percent in 2026, compared with 5.2 percent in the January 2026 forecast. The Research Department projected that GDP would grow by 5.5 percent in 2027, compared with 4.3 percent in the January forecast.
According to the July 2026 forecast, inflation is expected to be 1.8 percent in 2026 and 2027, compared with 1.7 percent and 2 percent, respectively, in the January forecast. The Research Department’s assessment is that the interest rate one year from now will be 3 percent.
In the July forecast, the projected deficit for 2026 stood at 4.9 percent of GDP—1 percent of GDP higher than the deficit projected in the January forecast, which had been prepared prior to Operation Roaring Lion. According to the July 2026 forecast, the debt-to-GDP ratio was expected to be 69 percent in both 2026 and 2027, compared with 68.5 percent in the January 2026 forecast.
The government is considering the possibility of increasing the 2026 defense budget later in the year by up to an additional NIS 25 billion, which would bring it to NIS 183 billion. Should this materialize, the deficit is expected to be higher than projected, at about 5.5 percent of GDP, while inflation over the coming year would be about 0.3 percentage points higher than projected, depending on the composition of the expenditure and its effect on the economy’s supply constraint.