Germany reshuffles the cards

As in other Eurozone economies, inflationary pressures in Germany are gradually easing, particularly in the energy and food sectors, despite some short-term volatility. In 2024, inflation stood at +2.2%, nearing the ECB’s target. In 2025, inflation is expected to ease only slightly, declining to +2.0%. This moderation will be tempered by a temporary rebound in food prices and still-elevated, though gradually softening, price pressures in the services sector. From 2026 onward, inflation is projected to decline further to +1.9%, supported by the delayed effects of earlier monetary tightening and easing labor cost pressures. Wage growth, a critical factor for the labor-intensive services sector, surged to +5.9% in 2023 and remained high at +5.3% in 2024. For 2025, wage growth is forecast to slow to +3.0%, followed by a further moderation to +2.8% in 2026. Nonetheless, upward pressure on wages may persist due to increased labor demand, particularly stemming from public investment initiatives linked to the national infrastructure fund.

Bold move to create space for defense and infrastructure spending

Despite multiple crises, Germany remains committed to fiscal discipline. In 2023, the general government deficit stood at -2.2% of GDP, while the debt-to-GDP ratio was near 63%, with expectations for further decline under the debt brake. However, a federal court ruling in late 2023 forced the government to implement spending cuts and reallocate resources. These tensions culminated in the collapse of the governing coalition in November 2024, following disagreements over how to close the 2025 budget gap and broader economic policy. As a result, Germany is operating under an interim budget until the new government coalition reaches an agreement (expected by mid-2025). At the same time, the government faces mounting fiscal pressures from geopolitical tensions, protectionism and rising pension and healthcare costs. There is also growing urgency to invest in the green transition, infrastructure, education and defense. In response, the Union and SPD have proposed creating new fiscal space through two key measures, anchored in the Basic Law: first, exempting defense spending above 1% of GDP from the debt brake; second, launching a EUR500bn special infrastructure fund over twelve years, equivalent to about 11% of GDP. This includes EUR100bn each for federal states and the Climate and Transformation Fund (KTF), and EUR300bn for infrastructure investments. To access these funds, two conditions must be met: a minimum 10% investment quota in the federal budget and proof of investment additionality. An expert commission will also be established to explore long-term reforms to the debt brake aimed at encouraging investment, signalling a shift toward a more flexible fiscal policy. Looking ahead, the fiscal deficit is projected at -2.8% in 2025 and -3.1% in 2026. The debt-to-GDP ratio is expected to rise slightly to 64.4% in 2025 and 65.4% in 2026.