Germany’s growth outlook revised downward due to energy shock, difficulties expected in the future

Europe’s biggest economy was expected to recover, but now it is being hit by soaring energy costs caused by the Iran war, and the federal government has cut its growth forecast in half.

Germany’s flagship fiscal stimulus package is in the spotlight as ministers scramble to cushion the impact of a hefty bill.

Before the war, the country had been supported by rising industrial orders, falling inventories and improving sentiment, thanks largely to government spending on defense and infrastructure.

But rising energy prices and supply chain risks are “undermining Germany’s Growth Party even before it took off,” said Carsten Brzeski, global head of macro research at ING.

The Federal Ministry of Economic Affairs and Energy this week lowered its growth forecast for 2026 from 1% to 0.5%, and for 2027 from 1.3% to 0.9%. Inflation is currently expected to reach 2.7% this year and 2.8% next year.

Brzeski pointed out that industrial production had already been “stagnant” since before the war, with a 0.3% month-on-month decline in February and flat year-on-year growth.

However, business sentiment is currently plummeting due to the Iran conflict.

On Friday, the Ifo Economic Research Institute’s latest Business Conditions Index, a key thermometer for gauging the mood of the German economy, fell to 84.4 in April, down from 86.3 in March and the lowest level since May 2020 at the beginning of the coronavirus pandemic.

Current rating decreased from 86.7 to 85.4 month-over-month, and future expectations decreased from 85.9 to 83.3. Separately, the ZEW Business Confidence Index in April fell 16 points to -17.2, its lowest reading since December 2022. The ZEW tracker fell from +58.3 in February to -0.5 points in March, indicating rapidly deepening pessimism about the country’s economic outlook.

“What we are seeing is that the German economy has been hit hard by the Iran crisis,” Ifo President Clemens Fuerst told CNBC on Friday. “Companies are telling us we have a tough road ahead.”

According to ING analysis, Germany remains one of Europe’s largest net importers of energy, with around 6% of it coming from the Middle East, while so-called “energy-intensive” industries, which employ around 1 million people, account for around 17% of gross industrial value added.

To cushion the energy shock – Brent oil prices have soared about 73% since the start of the year – Germany’s coalition government earlier this month agreed to a two-month tax cut on gasoline and diesel worth about 1.6 billion euros ($1.87 billion). Federal Minister of Economy and Energy Katerina Reisch said the federal government had “taken swift and decisive action to alleviate the burden” of rising fuel prices.

Brzeski said the war highlighted Germany’s heavy dependence on energy imports. “This is a stark reminder that simply shifting dependencies from Russia to the Middle East is not a structural solution,” he told CNBC in an email.

But Fuerst said it’s not just oil and gas supplies that are being disrupted by the conflict.

“It’s also intermediate products for the chemical industry, it’s affecting a wide range of intermediate products for the construction industry, petroleum-based products, and there’s a risk that there will be bottlenecks and a lot of production will stop,” he told CNBC’s “Squawk Box Europe.”

Market players had hoped that Germany’s massive fiscal stimulus package, including a 500 billion infrastructure investment fund for transport, digital and energy, and an increase in defense spending above the historic limit of 1% of gross domestic product (GDP), would boost the economy.

Festo said fiscal expansion remains a tailwind and is “even more welcome now.” “If we didn’t have that, the German economy would have shrunk,” he said, citing defense as one sector that continues to grow, supported by increased orders.

Brzeski said more than 200 billion euros earmarked for spending on infrastructure and defense was still on track and would continue to spill over into the economy. But he warned that some of that will likely be absorbed by higher energy prices and supply chain frictions, slowing overall progress.

“Overall, the war in the Middle East has painfully delayed Germany’s recovery, but has not yet derailed it,” Brzeski added.

Niklas Garnert, a German economist at Goldman Sachs, said this week’s cut in growth would not have a “significant impact” on fiscal spending.

“Based on current standards for energy prices, we expect fiscal measures amounting to about 0.1% of GDP, or between 4 and 5 billion euros, to be directed towards addressing rising energy costs this year and next. However, those measures should not replace fiscal policy spending,” Gurnard told CNBC via email.

Garnat does not expect significant additional measures, on top of the already announced tax breaks for a 1.6 billion euro fuel tax cut and a one-time inflation bonus worth about 3 billion euros.

“In fact, we expect spending to expand in the second half of this year, in line with historical patterns and continued increases in spending on infrastructure and defense,” Garnad added.

Economics Minister Reich acknowledged that fuel bailouts and other measures will not solve the deep problems behind Germany’s slow growth.

“In addition to broad structural reforms, we need a growing and competitive economy,” Reisch said in a statement announcing the downward revision to the growth outlook on Wednesday. “Our companies need air to breathe again.”

Brzeski said high energy prices were diverting the government’s focus from overdue structural reforms to short-term support, which he said was “not a very promising strategy.”

He added: “Germany urgently needs a better and more active energy strategy that ensures greater autonomy and competitive prices.”

“It doesn’t matter whether we go all-in on renewable energy or rethink nuclear power. What matters is that the government finally comes up with a long-term strategy.”