German inflation cools on fuel tax cut, economy grows more than expected in Q3

By Miranda Murray

BERLIN, Oct 30 (Reuters) - German inflation slowed more than expected in October, the first month of a government fuel tax cut, adding to evidence that Europe's largest economy could prove more resilient than anticipated despite disruptions linked to the war in Iran.

Gross domestic product increased slightly more than expected in the third quarter, though economists warned the expansion remained heavily reliant on government spending.

Inflation eased to 2.8% year-on-year in October from 3.3% the month before, preliminary data from the statistics office showed on Friday, below forecasts for 3.1%.

EASING ENERGY PRICES

Easing energy price rises drove the slowdown, increasing by 12.2% in October versus 14.9% the month before, and indicated that the fuel tax cut that runs to year-end is having an effect.

Core inflation, which excludes volatile food and energy prices, fell to 2.1% from 2.4% the month before.

The German data comes ahead of a euro zone inflation update due on Wednesday. Inflation in the bloc is expected to come in at 3.9% in October, slightly above September's 3.8%, according to economists polled by Reuters.

ECONOMY

German GDP increased by 0.2% in the third quarter compared with the previous three-month period, according to preliminary data from the statistics office, slightly above a rise of 0.1% forecast by analysts polled by Reuters. 

The data pointed to a fourth straight quarter of recovery in Europe's largest economy, helped by increased public spending, even as private sector momentum remained subdued.

Under Chancellor Friedrich Merz, government funding has surged since Berlin last year approved a €500 billion ($560 billion) infrastructure fund and exempted much defence spending from its debt brake rules.

The economy grew by 0.3% in the second quarter and 0.4% in the first quarter, according to the office.

The fuel tax cut, which aims to cushion households from the surge in oil prices caused by the Iran war, will likely help the economy hold up in the fourth quarter as well, said Deutsche Bank analyst Marc Schattenberg.

However, with no sign of a lasting de-escalation in the Middle East, energy prices are unlikely to drop noticeably and will continue to stoke inflation in coming months, say analysts.

 "It is clear that the inflation rate will hover around 3.0% for some time to come," said Alexander Krueger, chief economist at Bethmann HAL bank. 

"Given this backdrop, an interest rate hike by the ECB cannot be ruled out."

The European Central Bank left interest rates unchanged on Thursday but clearly hinted at another hike in December.

GOVERNMENT SPENDING DRIVES RECOVERY

While analysts broadly agree Germany is emerging from a prolonged slowdown, many stop short of calling the recovery self-sustaining because private investment remains weak.

A lack of sweeping reforms means Germany's attractiveness as a place to do business will remain impaired, preventing a significant recovery in private investment, Commerzbank chief economist Joerg Kraemer said.

Analysts pointed to the increased government spending on infrastructure and defence as the main driver of the recovery. 

"Without this artificially initiated impulse, economic output would probably have stagnated," said Krueger.

Jens-Oliver Niklasch, economist at LBBW bank, said that next year would reveal whether the economic revival is sustainable or just a flash in the pan. 

"For sustained, higher growth, investment would need to pick up more substantially, which, to date, has not been the case," he said. 

The German government expects the economy to grow by 1.3% in 2026 and 1.1% in 2027, with the economy ministry saying earlier this month that the Iran war, and resulting high energy prices, is not hurting the economy as much as feared. 

In a further positive sign, the Ifo economic institute's closely watched business climate index rose for a sixth straight month in October.

($1 = 0.8930 euros)

(Reporting by Miranda Murray; Editing by Toby Chopra)