Non-final working translation

The war in the Middle East is putting fresh strain on the global economy. The focus here is on the blockade of the Strait of Hormuz, the world’s most important transport route for fossil fuels. One-fifth of the global supply of oil and liquefied natural gas passes through the Strait under normal conditions. The blockade of this passage combined with the war-related damage to energy infrastructure in the region led to a sharp rise in energy prices. The associated cost and price hikes are likely to have a marked dampening effect on global economic activity and increase inflation. This much is also indicated by the most recent global surveys among purchasing managers. Business prospects worsened across the board. At the same time, price pressures intensified significantly across the various stages of production.

However, the global economy held up well in the first quarter. Lively demand for high-tech products in the wake of the AI boom provided a notable boost to the global trade in goods, which contributed to stronger economic growth in China. In the United States, GDP saw a return to more robust growth, partly thanks to buoyant investment activity, which was also connected with the AI boom. On the other hand, the pace of expansion slowed in the euro area. 

The size of the economic burdens will depend primarily on the duration and intensity of the conflict. The Strait of Hormuz has remained largely closed owing to the Iranian and US blockades, even following the ceasefire that has since been negotiated. Oil prices have fluctuated at high levels in recent weeks, following a surge in March and April. At the current end, Brent crude oil stood at around US$117 per barrel, some 63 % higher than before the war began and 88 % higher than at the beginning of the year. The prices of individual petroleum products, such as diesel and kerosene, rose even more sharply. In Europe, stocks of petroleum products currently appear to be sufficiently full, but if energy supplies from the Persian Gulf continue to be disrupted, the supply situation is likely to become increasingly tense.

Higher energy prices made a substantial contribution to the marked rise in global consumer price inflation. In advanced economies, annual consumer price inflation accelerated to 3.4 % by April, up from 2.3 % in January. In the narrower core definition, excluding energy and food, the inflation rate rose slightly to 2.6 %. Persistently high energy commodity prices are expected to further increase costs along the entire value chain over the coming months and additionally intensify consumer price inflation. 

The Iran war has influenced financial markets through two main channels: rising inflation expectations and a gloomier economic outlook. From the start of the US-Israel war with Iran, the impacts of higher energy commodity prices were swiftly reflected in bond, foreign exchange and equity market valuations. Short-term market-based inflation expectations rose considerably, especially in the euro area, and market participants expected a higher future level of policy rates. This pushed up long-term sovereign bond yields, reduced risk appetite and weighed on the markets for risky assets.

Longer-run inflation expectations, however, remained anchored to the 2 % medium-term inflation target. The euro came under pressure against the US dollar during this period. Risk appetite, euro and equity valuations recovered markedly following the announcement of a ceasefire in the Iran conflict at the beginning of April, with the most adverse scenarios for energy commodity markets initially appearing less likely. Long-term sovereign bond yields nevertheless remained elevated, particularly owing to expectations of higher short-term interest rates in the future increasing of late. In addition, market participants’ confidence in a swift resolution to the conflict and a normalisation in energy markets subsequently took a setback. It remained unclear whether and when the Strait of Hormuz – vital to energy commodity markets – would be passable to shipping again. Despite this, US equities recently reached a new all-time high as risk appetite grew. Gains in European equities were smaller amid persistently high energy prices and a gloomier economic outlook for Europe. The euro fell again recently, as surprisingly high US inflation figures pushed up policy rate expectations in the United States.

The Governing Council of the ECB left key interest rates on hold at its monetary policy meetings in March and April 2026. The war in the Middle East and its impact on energy prices have significantly increased uncertainty surrounding the economic outlook for the euro area. Average headline inflation was revised upwards, especially for 2026, in the March staff projections baseline scenario. The baseline scenario, which is based on market expectations for short-term interest rates, assumes two to three interest rate hikes in the second half of the year. In addition, the Governing Council judges that there are upside risks to inflation and downside risks to economic growth. The scenario analysis suggests that the prolonged disruption in the supply of oil and gas raised inflation above the baseline scenario and reduced growth accordingly.

Monetary growth stabilised in the first quarter of 2026. The annual growth rate of M3 stood at 3.2 % at the end of March, somewhat higher than at the end of the previous quarter. This robust growth was mainly driven by a continued build-up of overnight deposits and increased investor interest in money market funds and short-term bank debt securities, which are both remunerated at close-to-market interest rates. Bank lending to non-financial corporations remained on an upward trajectory, although the share of long-term loans has declined significantly of late. Lending to financial corporations and households also continued on their recovery path. In addition to lending, increased foreign demand for domestic securities, especially government bonds, shares and investment fund shares, contributed to monetary dynamics.

German economic output increased surprisingly strongly at the beginning of the year. According to the Federal Statistical Office’s flash estimate, real GDP rose by 0.3 % on the quarter after seasonal adjustment. Economic output had already gone up 0.2 % in the previous quarter. In the face of many burdens, the German economy is thus more robust than previously expected. Higher government consumption is likely to have contributed to this rise. In addition, industry proved to be quite resilient. Industrial production declined in the first quarter, but price-adjusted industrial sales rose somewhat and exports of goods increased markedly. It appears that the German economy was once again able to participate in growing global demand somewhat more actively. Increased activity in the defence industry is also likely to have bolstered industry. In spite of this, capacity utilisation in industry remained weak overall and weighed on private investment in machinery and equipment. Service providers also contributed to the increase in GDP, but probably mainly the less consumer-oriented sectors. This is because deteriorating labour market conditions, smaller wage growth and, in particular, the sharp rise in consumer prices since March in the wake of the war in the Middle East are likely to have dampened private consumption. In the construction sector, unfavourable weather conditions led to a temporary decline in output.

Against this backdrop, credit developments remained subdued. Declining consumer confidence, a slight increase in lending rates and an upward trend in house prices dampened households’ demand for loans for house purchase. Banks’ lending business with non-financial corporations remained weak given the challenging macroeconomic environment. The banks surveyed in the BLS continued to tighten their credit standards for corporate clients in the first quarter of 2026 as they perceived credit risk to be elevated. However, there has so far been no additional tightening as a result of the war in the Middle East. 

The labour market was unable to benefit from fairly strong economic growth in the first quarter. The decline in employment was in fact slightly stronger than in the fourth quarter. Employment subject to social security contributions is now likewise in decline. And unemployment recently rose again after a protracted period of stability. Moreover, the leading indicators show no signs of an imminent improvement. 

At 2.8 %, growth in negotiated wages in the first quarter of 2026 was weaker than before, but still quite strong. With a year-on-year rise of 3.2 % in the first quarter, basic pay, from which special and one-off payments are factored out, was significantly weaker than in the fourth quarter. The old wage agreements with higher incremental increases are gradually expiring. Their impact is thus declining. And the most recent wage agreements were lower than in previous years. There are no signs so far that the rise in inflation caused by the war in the Middle East is leading to significantly higher wage demands. As things currently stand, wage growth is unlikely to accelerate over the coming months. 

Consumer prices rose markedly in the first quarter, mainly as a result of higher energy prices. Averaged across January to March 2026, consumer prices as measured by the HICP rose by a seasonally adjusted 0.7 %, compared with 0.6 % in the preceding quarter. This was mainly due to the sharp rise in energy prices at the end of the quarter in connection with the war in the Middle East. Fuel and heating oil, in particular, appreciated significantly in March, driven primarily by higher crude oil prices. Services inflation declined somewhat compared with the previous quarter, but remained above average by historical standards. This is in line with the easing but still elevated growth in wage costs. The annual inflation rate remained unchanged in the first quarter of 2026, at 2.3 %. Core inflation excluding energy and food, meanwhile, fell slightly, from 2.7 % to 2.5 %.

Following the significant rise in March, the inflation rate increased further to 2.9 % in April. Energy prices, in particular, went up again steeply. As before, this was driven mainly by fuel and heating oil prices. Prices for services rose markedly in some areas. At the same time, however, a base effect stemming from the fact that Easter fell later than in the previous year significantly dampened inflation. Accordingly, core inflation excluding energy and food fell somewhat from 2.5 % in March to 2.3 % in April.

Inflation is likely to remain elevated over the coming months amid upside risks. However, the outlook depends, first and foremost, on further developments in the war in the Middle East. This is mainly due to the sharply higher energy commodity prices since the conflict in the Middle East escalated. Moreover, higher energy, production and transport costs are also expected to gradually pass through to prices for food, non-energy industrial goods and individual services. However, there is considerable uncertainty as to how large these effects will be and how long they will last. Like the direct effects via higher energy prices, indirect effects depend largely on how the war evolves. Moreover, a marked rise in the inflation rate always carries the risk of second-round effects. This would be the case, for example, if the original price shock were reflected in higher wages or inflation expectations or a changed price setting. However, in Germany, second-round effects via wages usually only occur with a fairly lengthy lag and, above all, when the rise in inflation is accompanied by higher aggregate demand. Inflation expectations, meanwhile, could adjust more quickly given recent experience with very high inflation rates. In May and June, the temporary reduction in the energy tax on petrol and diesel is likely to temporarily shave around ¼ percentage point off the inflation rate.

The effects of the war in the Middle East are weighing on the German economy more broadly and more noticeably in the second quarter. Higher inflation and the associated losses in purchasing power are weighing on private consumption and thus on consumer-related service providers. The losses in purchasing power are also likely to dampen demand in housing construction. High energy prices and greater supply bottlenecks are weighing on industry and construction on the supply side. In addition, heightened uncertainty is likely to dampen industrial production and business investment. The rise in interest rates as a result of the war is a further drag on private investment. However, the expansionary fiscal policy is probably increasingly supporting economic activity. Overall, as things currently stand, real GDP is therefore likely to roughly stagnate in the second quarter. However, how heavy the war will weigh on the economy will depend crucially on how long it lasts. 

Government finances are currently characterised by expansionary fiscal policy. The deficit will rise owing to sharp expenditure growth. It is expected to expand to around 4 % of GDP this year (2025: 2.7 %). Without further intervention, the deficit ratio will keep rising in 2027 and converge very closely on the 5 % mark. The strong increase in expenditure in these years is driven in large part by additional spending on defence as well as on pensions, healthcare and long-term care. The increases come on top of a high structural expenditure ratio, which stood at almost 50 % last year. Pressure on government finances is also reflected in the high contribution rates of the social security funds, which surged to a total of 42½ % in 2025 and are set to rise markedly further going forward. The debt ratio will increase significantly (2025: 63.5 %).

Looking further ahead, central government’s plans up to 2030 are in line with a general government deficit ratio of just over 4 %. Central government has structural scope for borrowing of 0.35 % of GDP, supplemented by its debt brake exemption for defence spending and the Infrastructure and Climate Neutrality Fund. For 2028 to 2030, central government’s structural net borrowing is expected to stand at just under 4 % of GDP with the new benchmark figures. On top of this, state governments have structural scope for borrowing of 0.35 % of GDP. As a general rule, local governments are required to strictly limit their deficits. The social security funds generally have to balance their budgets without borrowing. The pension insurance scheme will therefore, starting in 2028, bring down its deficit by means of higher contribution rates as it will have exhausted its flexible reserves by then. Looking ahead, the other pillars of the social security funds will have to manage again without central government loans. 

With a deficit ratio of around 4 %, the debt ratio is increasingly moving away from the 60 % reference value. Higher debt is also accruing at the EU level. The portion of the debt for which Germany is accountable is expected to grow to 3½ % this year. 

Central government will have to adopt major adaptation measures in the future in order to comply with debt brake requirements. In other words, funding gaps shown in the benchmark figures need to be closed by means of concrete measures and any new burdens placed on the budget covered within the framework of the regular budget. The gaps are increasing over time and are likely to amount to €60 billion in 2030. To truly improve defence capabilities and infrastructure, it is also advisable to utilise the available borrowing capacity more extensively to increase spending in these areas. As things currently stand, it appears that central government will use a large portion of this scope to close budget gaps and finance other policy objectives. The same seems to be the case for state and local governments with respect to the share of the Infrastructure and Climate Neutrality Fund that is available to them. 

State government finances are in relatively good shape overall. By contrast, local government finances require considerable consolidation. State governments are also tasked with ensuring that their local governments’ finances are sustainable, particularly as part of their budgetary oversight. If other resources intended to consolidate local government budgets have been exhausted, state governments are called upon to resolve this issue using their own resources. It would be extremely worrying if state governments were to allow major fiscal imbalances in local governments to re-emerge. To counter this as early as possible, the Bundesbank would find it helpful if local governments were only allowed to take out cash advances from their state governments where these do not simply bridge short-term funding gaps. It would also make sense to require state governments to count these loans towards their own credit limits under their debt brakes. This would make unwelcome developments in local government finances visible in state government budgets in a timely manner, meaning that they could potentially be addressed more promptly.

Germany is also planning to exceed the EU reference value for the deficit ratio in 2026 and 2027, even after deducting the exempted defence expenditure. The Stability Council warned in May that there is a risk of an excessive deficit in 2026. The logical step would therefore be for central government and state governments to take measures to avert this. 

To reliably safeguard sound government finances again in future and to comply with EU rules, central government legislators ought to adjust the debt brake. The Federal Government convened an expert commission on this topic. Last autumn, the Bundesbank presented a reform proposal aimed at firmly anchoring a framework for sound government finances whilst also protecting government investment. Ultimately, it is up to legislators to agree on suitable requirements and to enshrine them in the Basic Law. Regardless of the specific design, it is essential to gradually phase out the sectoral exemption for defence spending and to once again set a sufficiently ambitious ceiling for borrowing.

Fundamental reforms have been announced for healthcare, long-term care and pensions. Minor adjustments are unlikely to be enough to rein in the rapid growth in spending and the currently envisaged sharp rise in contribution rates. With regard to central government grants, it is important to keep in mind that central government finances are under immense strain. Any increase in central government grants only add to this strain and would therefore need to be offset elsewhere.