Germany's recent rise in public expenditure - concentrated on defence and major infrastructure projects - is expected to be the decisive factor preventing the economy from contracting this year, the Bundesbank said on Friday. The central bank described the fiscal expansion as sufficient to largely offset the economic shock from the war in the Middle East, which has pushed up energy prices and added to inflationary pressures across Europe.
The Bundesbank noted that Germany's economy has been broadly stagnant over the past three years. Policymakers had anticipated that a notable increase in government spending would help restart growth in the current year, but that recovery has been undermined by a war-related rise in energy costs.
The bank revised its growth outlook downward. It now expects the economy to expand by 0.5% in 2026, compared with a 0.6% forecast published in December. The forecast for 2027 has been cut to 0.8% from 1.3%.
Those revisions come a day after the European Central Bank lowered its own euro zone growth projection while still deciding to raise interest rates to combat inflation. In that context the Bundesbank emphasized fiscal policy's offsetting role. "Expansionary fiscal policy will be the only thing preventing a decline in gross domestic product in the summer half-year," the bank said. "It will more or less offset the impact of the war in the Middle East."
The Bundesbank quantifies the contribution from government spending - particularly defence outlays - as a cumulative boost of 1.3 percentage points to growth through 2028. At the same time it warned that the surge in energy costs will erode household purchasing power and that firms may face mounting supply bottlenecks alongside weaker demand.
In addition, the central bank said uncertainty and elevated interest rates will act as a drag on private investment, even if the direct effects of the war are expected to abate in the years ahead.
"Risks are clearly tilted to the upside for inflation and to the downside for economic activity," the Bundesbank said.
The bank does not expect underlying price growth - that is, inflation excluding volatile food and energy components - to fall back below the ECB's 2% target during its forecast horizon through 2028. Overall inflation in Germany is projected at 2.9% this year and 2.7% in 2027.
Core inflation is forecast at 2.6% for this year, 2.5% in 2027 and 2.3% in 2028. Those projections underpin Bundesbank chief Joachim Nagel's observation that the ECB would be prepared to raise interest rates again in July, if needed, and mirror the ECB's assessment that returning core inflation to 2% will be challenging.
While the Bundesbank attributes Germany's avoidance of an immediate recession to fiscal stimulus, it also highlighted several constraints on a more durable, private-sector led upswing: elevated energy costs hurting household incomes, potential supply-chain frictions and weaker demand for firms' products, and the dampening impact of higher borrowing costs and uncertainty on investment decisions.