German government spending only thing preventing GDP fall, Bundesbank says

FRANKFURT, June 12 (Reuters) - Heavy government spending on defence and infrastructure will stop Germany from slipping into recession this year, as the war in Iran takes its toll on Europe's biggest economy and lifts inflation, the Bundesbank said on Friday.

Germany’s economy has been broadly stagnant for the past three years, with a jump in spending expected to restart growth this year, only for a war-driven surge in energy prices to derail the recovery.

The world's third-largest economy is now expected to grow just 0.5% in 2026, below the 0.6% forecast in December, while 2027 growth was cut to 0.8% from 1.3%, the Bundesbank said a day after the ECB lowered its own euro zone growth forecast but still raised interest rates to combat inflation. 

"Expansionary fiscal policy will be the only thing preventing a decline in gross domestic product in the summer half-year," the Bundesbank said. "It will more or less offset the impact of the war in the Middle East."

The bank estimates that government spending, particularly on defence, will boost growth by a cumulative 1.3 percentage points up to 2028.

But high energy costs will dampen households' purchasing power while businesses may also be facing increasing supply bottlenecks and weaker demand. 

In addition, uncertainty and higher interest rates will also prove a drag on private investment, even if the impact of the war should fade over the coming years, the Bundesbank added.

"Risks are clearly tilted to the upside for inflation and to the downside for economic activity," the bank said.

In its monthly report, Germany's economy ministry on Friday also warned of the dampening effect of high energy costs on demand.

It said Germany's economy would only recover in small steps at best and the labour market showed no sign of improving over the next few months.

The Bundesbank does not expect underlying price growth, which filters out volatile food and energy prices, to come back below the ECB's 2% target through its 2028 forecast horizon.

Overall inflation in Germany is expected to be 2.9% this year and 2.7% in 2027, underpinning Bundesbank chief Joachim Nagel's comments that the ECB will be ready to raise interest rates again in July, if necessary. 

Underlying inflation is meanwhile seen at 2.6% this year, 2.5% in 2027 and 2.3% in 2028, mirroring the ECB's own projection that bringing core inflation back to 2% may be difficult.          

(Reporting by Balazs Koranyi;Editing by Elaine Hardcastle)