Israel's Growth Dilemma: Rate Stability Amid Trade Headwinds

The Bank of Israel’s April 2025 decision to hold its policy rate at 4.5% while revising its GDP growth forecast downward to 3.5% for 2025 underscores a critical balancing act for Israeli policymakers. With inflation still above target and global trade tensions escalating, the central bank’s cautious stance reflects both resilience in domestic fundamentals and vulnerabilities tied to external shocks. For investors, this creates a landscape of opportunity in select sectors but demands vigilance toward geopolitical and macroeconomic risks.

Rate Stability: A Delicate Equilibrium

The Monetary Committee’s decision to stand pat on rates highlights its dual mandate challenges. While headline inflation remains elevated at 2.6% for 2025 (above the 1.0–3.0% target), core inflation pressures are easing, and market expectations for 2026 are within range. This has emboldened the Bank to signal a potential easing cycle, with most panelists predicting 50 basis points of cuts by early 2026. Yet, the committee’s reluctance to act immediately underscores lingering risks: a spike in global oil prices or renewed conflict in Gaza could reignite inflation.

Growth Revisions: Trade War Drag Weighs on Exports

The Bank’s revised GDP forecast—from 4.0% to 3.5% in 2025—stems primarily from U.S. import tariffs and retaliatory measures, which now threaten to reduce Israeli exports by 4% by 2026. This external headwind is most acutely felt in goods exports to the U.S., which account for 13% of total exports. While tourism and defense exports (driven by global demand for cybersecurity and drone tech) may partially offset losses, the overall drag on GDP is projected at 0.5 percentage points annually through 2026.

Inflation and Public Finances: A Mixed Picture

Inflation is expected to trend downward to 2.2% in 2026, aided by falling global oil prices (Brent crude at $65/barrel) and supply-side improvements. However, labor market tightness—projected unemployment of 2.9% in 2025—remains a wildcard, as wage growth could reignite price pressures. On the fiscal side, the deficit is narrowing to 4.2% of GDP in 2025, supported by tax reforms and one-off revenues like the sale of Wiz, a state-owned telecom. Public debt is stabilizing at 69% of GDP, offering some buffer against shocks.

Policy Outlook and Investment Implications

The Bank’s gradual easing path—implying rate cuts from 4.5% to 4.0% by early 2026—aligns with a soft-landing scenario. For investors, this suggests opportunities in sectors insulated from trade wars:
1. Defense and Cybersecurity: Israel’s tech-driven defense exports are a growth pillar, with global demand for drone systems and cybersecurity solutions surging. Companies like Elbit Systems and Rafael Advanced Defense Systems stand to benefit.
2. Construction and Infrastructure: Post-conflict rebuilding and easing labor shortages could boost construction activity, making firms like Shikun & Binui or infrastructure funds attractive.
3. Tourism and Consumer Staples: Tourism rebounding from pandemic lows and resilient domestic consumption (despite tax hikes) favor hospitality and consumer goods firms.

Risks, however, are asymmetric. A deeper trade war or escalation in Gaza could subtract another 0.5% from GDP in 2025 while pushing inflation higher. Geopolitical instability remains the key wildcard, with markets likely to react sharply to any conflict flare-ups.

Conclusion: Navigating Uncertainty with Precision

Israel’s economy is navigating a narrow path between rate stability, trade headwinds, and geopolitical risks. While the Bank’s forecasts suggest a soft landing is achievable, investors must prioritize sectors with defensive characteristics or direct linkages to global demand (e.g., defense tech). The revised GDP forecast of 3.5% for 2025, paired with a narrowing fiscal deficit, indicates resilience but not robust expansion.

Crucially, the Bank’s April projections—anchored by its DSGE model—rely heavily on assumptions about trade tensions and conflict resolution. If U.S.-Israeli trade relations deteriorate further or Gaza hostilities intensify, the 0.5% GDP downside risk could materialize, pushing inflation back above targets. For now, the data points to a cautious bullish stance on Israeli equities, but with a watchful eye on geopolitical developments.

In this environment, investors should overweight sectors with pricing power (e.g., defense) and underweight export-reliant industries. Monitoring key indicators—such as Brent crude prices, U.S. tariff developments, and monthly GDP data—will be critical to calibrate exposures as the year progresses.