Israel's financial markets shrugged off the April 13 Iranian missile strikes and they will have a minimal economic impact in the short term, say analysts. The key concern now hinges on what Israel decides to do next. Will it hit back and escalate a cycle of violence that has already gone up a notch with Iran’s first-ever direct military strike against Israeli territory? A more extensive regional conflict would significantly influence everyone’s economy.

“An aggressive Israeli military response that leads to direct conflict with Iran is a major downside risk for the economy. But a more prolonged war effort in Gaza now looks possible, which could weigh on Israel’s recovery, add to fiscal strains, put the shekel under pressure and delay further interest rate cuts,” Liam Peach, the senior emerging market economist with Capital Economics, said in a note.

The Iranian offensive, a retaliation for the bombing of Iran's consulate in Damascus in Syria on April 1st that killed seven Revolutionary Guard members, did not substantially disrupt Israel's robust defence systems. While Iran is significantly bigger than Israel, its modern, well-equipped and technologically advanced military makes Israel the more militarily formidable of the two countries.

Conscious of the chaos a region-wide conflict would cause, Tehran’s Goldilocks Retaliation was measured, designed to be a show of force, but limited enough not to provoke Israel into a significant riposte. Tehran telegraphed the attack well in advance and targeted a military airbase deep in the desert, just suffered minimal damage. One ten-year-old was hurt. No fatalities were reported.

“How things play out from here is highly uncertain, and we do not claim expert insight. The two biggest uncertainties after the attacks in Syria two weeks ago were Iran’s likely response and Israel’s appetite for a more aggressive stance with Iran. Iran’s strikes were interpreted as calculated and measured. The US and Iran do not appear to want an escalation, but it is unclear where Israel now stands,” says Peach.

Looking forward, the geopolitical landscape remains fraught with uncertainty. Israel has lately adopted a more assertive stance against Iranian influence in the region, frequently targeting locations in Lebanon and Syria where bombings and airstrikes have been incessant. The United States is a major restraint on Israel and has explicitly stated it will not engage in offensive operations against Iran, telling Israeli Prime Minister Benjamin Netanyahu to back off.

Israel's war cabinet, led by moderate figures including former defence minister Benny Gantz, suggests the call for another but balanced military response may prevail. However, hardline elements within the government have advocated for a solid retaliation to Iran's provocations.

“A military response that leads to direct conflict with Iran would, of course, have a significant impact on Israel, but even if this doesn’t materialise, it’s possible that Israel steps up efforts in Gaza to achieve its objectives in eliminating Hamas and tensions ignite on the northern front,” says Peach.

Israel's economic activity has rebounded since the October 7 Hamas terrorist attack, when the economy contracted by almost a fifth in the quarter. And sectors like leisure, construction, and tourism remain vulnerable to prolonged tensions or worse.

The national budget deficit is of special concern and is projected to reach 6.5% of GDP this year, driven up by increased military expenditures and a sustained high debt ratio adding to fiscal pressures.

“The war has pushed up Israel’s risk premia, and this could continue. CDS rose from 110bp in early April to 140bp last week, the highest since October. We’ve argued that fiscal tightening (of more than 2% of GDP) is needed to stabilise the debt ratio from 2025. The size of the adjustment will rise if the conflict intensifies and drags for longer,” says Peach.

The Israeli central bank's monetary policy also hangs in the balance. With geopolitical tensions high and inflationary pressures increased by state spending, significant easing seems improbable.

The shekel, having slightly appreciated against the dollar recently, faces potential volatility depending on how the conflict evolves. “The currency is up 1% against the dollar since Friday, to 3.72/$, but it’s hard to make a case for it to return to the 3.60/$ range it was at just a few months ago. Our current view remains that it will stabilise around its current levels this year,” says Peach.

Provided that inflation remains within the central bank’s 1-3% target range, the conflict with Iran doesn’t escalate further and the exchange rate is stable, there should be scope for the central bank to restart its monetary easing cycle later this year.

“But it’s looking more likely to us that it might only deliver one more 25bp cut this year (our current forecast is 50bp of easing, to 4.00%, by year-end),” says Peach.