Will German fiscal stimulus boost inflation much?

Capital Economics projects Germany's upcoming fiscal stimulus will have a limited impact on inflation, forecasting core inflation to rise only slightly above 2% despite a widening budget deficit. The report cites that increased spending is primarily allocated to defense and infrastructure, which have minimal direct impact on the Harmonized Index of Consumer Prices (HICP), and that broader wage-driven inflation will be tempered by spare labor capacity, slow wage adjustments, and low headline inflation. They forecast core inflation to decline from 2.8% in 2025 to 2.3% in both 2026 and 2027.

Analysis

Germany's planned fiscal stimulus is projected to have a marginal impact on inflation, despite an expected widening of the budget deficit from 2.8% of GDP in 2024 to approximately 4% by 2026-2027. According to Capital Economics, the stimulus is unlikely to breach the European Central Bank's 2% target, with core inflation forecast to decline to 2.3% by 2026. This muted inflationary effect is attributed to the allocation of funds primarily towards defense and infrastructure, sectors with minimal direct weighting in the Harmonized Index of Consumer Prices (HICP); materials and services for home maintenance, for instance, constitute only 1.3% of the HICP basket. Furthermore, significant wage-driven inflation is considered improbable due to three key factors: existing slack in the labor market, evidenced by unemployment rising to 3.7% and increased use of short-time work schemes; slow structural wage adjustment mechanisms tied to multi-year collective agreements; and moderating wage demands in response to lower headline inflation, a trend the Bundesbank has already observed. The stimulus is not expected to meaningfully increase household disposable income, as capital will flow mainly to firms producing investment goods, limiting the direct impact on consumer spending.

Key Decisions for Investors

• Given that Germany's fiscal expansion is unlikely to fuel significant Eurozone inflation, investors should factor in a reduced probability of a hawkish European Central Bank policy response, which may support European fixed-income valuations.
• Consider targeted exposure to European infrastructure, defense, and construction-related industrials, as these sectors are the direct beneficiaries of the stimulus spending, while the limited pass-through to consumer demand warrants a more neutral stance on consumer-facing sectors.
• Monitor German labor market data, particularly wage settlements and unemployment figures, as any significant deviation from the forecast of contained wage growth would be the primary catalyst to challenge this non-inflationary outlook.