The economy is projected to stagnate in 2024 and grow by 0.7% in 2025 and 1.2% in 2026. Low inflation and rising wages will support real incomes and private consumption. Private investment will gradually pick up, supported by high corporate savings and slowly declining interest rates, but policy uncertainty will continue to weigh on investor confidence. Exports will slowly recover as demand in key trading partners strengthens.

Increasing public spending efficiency, reducing environmentally harmful tax expenditures, and enhancing tax enforcement should be combined with more flexibility in the national fiscal rules to create fiscal space to address a large infrastructure backlog and support green and digital investments. Continuing to reduce the administrative burden, digitalise the public administration and improve infrastructure implementation capacity, particularly at the municipal level, can do much to support a pick-up in public and private investment. Skilled labour shortages can be addressed by strengthening the work incentives of women, older workers and low-income earners, as well as improving education, training and adult learning policies.

After GDP had decreased by 1.1% (annualised rate) in the second quarter 2024, it picked up by 0.4% in the third quarter driven by private and public consumption. High uncertainty about the financing and design of measures to support the green transition is weighing on investor and consumer confidence. Industrial production was 4.6% lower in September than a year earlier. Despite falling energy prices, output of energy- intensive industries was 2% lower in September than a year earlier and volatile car production declined after a strong increase in August. However, incoming manufacturing orders have significantly picked up in September (+4.2%). Annual headline inflation increased to 2.4% in October, up from 1.8% in September, mainly driven by increases in food as well as services prices. Core inflation remains sticky at 3.3% in October, up from 3.0% in September, due to strong services price inflation of 4.8% in October. Nominal wages per employee increased by 5.1% in the third quarter of 2024 from a year earlier, pushing up real wages and supporting a recovery in retail sales volumes from July to September. Although labour markets show some signals of cooling, they remain robust with a stable unemployment rate and high vacancies relative to historical norms, still signalling strong labour shortages.

After increasing in both July and August, export values declined in September by 1.7%. Exports to non-EU countries declined further in October and remain 6.5% below the level in October 2023, mainly due to weak exports to China and the United States. However, export orders have rebounded in recent months due to a broader recovery in global demand.

The fiscal stance will tighten in 2024 and 2025 by 0.6% and 0.4% of GDP, which supports ongoing disinflation, and remain broadly neutral in 2026. The tightening partly reflects the impact of the November 2023 Supreme Court ruling that declared the use of special funds to finance investments in consecutive years as unconstitutional. The ruling has led to a reduction of available funds in the Climate and Transformation Fund (KTF) by EUR 60 billion and the closure of the energy support fund. This has significantly reduced spending on public investments and fiscal incentives for private investments of households and firms for the green transition. Subsidies for electric vehicles (EV) were phased out in January 2024, which contributed to a large drop in sales, and plans to extend subsidies to reduce energy costs of firms until 2030 were cancelled. In total, KTF spending was reduced by a quarter to 1.1% of GDP in 2024 and by half to 0.6% of GDP in 2025. The closure of the energy support fund led to the phasing out of energy price support measures in January 2024 and the cancellation of the planned grid charge reductions.

Medium-term uncertainty remains high after the failure to conclude negotiations on the 2025 budget and the fall of the coalition government. A provisional budget for 2025 will extend spending levels from 2024 to 2025 resulting in tighter fiscal conditions than expected. Several projects related to the Climate and Transformation Fund were put on hold after the 2023 supreme court ruling and the financing of about a third of the remaining projects in 2025 is still to be decided. Planned spending of 1.9% of GDP in 2024-2025 from a special defence fund has not been affected by the ruling. To revive economic growth, the government had planned to implement several measures, including more generous depreciation allowances for investments, fiscal incentives for EV purchases, reductions in administrative burdens, and fiscal incentives to raise labour supply of older workers and migrants. However, most of these measures will likely not be adopted before the early elections planned in February 2025.

After stagnating in 2024, GDP will grow by 0.7% in 2025 and 1.2% in 2026. Rising nominal wages, falling inflation and declining interest rates will support a recovery in private consumption. The gradual easing of financial conditions, large corporate cash buffers and investment needs due to supply-chain realignments, digitalisation and the green transformation will allow investment to pick up slowly, despite the uncertainty about the financing and design of support measures for firms and workers during the green transition. Export growth will strengthen in 2025, as key export markets recover. With restrictive fiscal policy and falling energy prices, headline inflation will converge towards 2% in 2025, but core inflation will be sticky, reflecting the impact of wage gains amidst skilled labour shortages.

A prolonged period of policy uncertainty related to the financing and design of support measures for firms and workers during the green transition could hamper a recovery in consumer and investor confidence and hold back business investment and private consumption growth. Further increases in international trade barriers would particularly affect the German manufacturing industry, which is highly integrated in global value chains. An escalation of tensions in the Middle East could lead to further energy or commodity price rises and result in more supply chain disruptions, reducing industrial production and exports. On the upside, a stronger recovery in China could significantly improve exports of investment and other goods.

To boost investment, it is crucial to raise administrative capacities for infrastructure planning and continue simplifying planning and approval procedures at subnational levels. Speeding up digitalisation will require more investment in digital infrastructure and a more rapid modernisation of the public sector, including by setting mandatory common IT standards and encouraging the harmonisation of administrative procedures across levels of government. Skilled labour shortages are also a major barrier for investment. Shifting the tax burden away from labour towards capital income and wealth, for example by reducing inheritance tax exemptions for business assets and capital income tax exemptions for investments in existing buildings, would help improve labour supply incentives. This should include reforming the current joint income taxation and health insurance of couples, which lead to very steep marginal income tax rates for second earners and contribute to more than half of all working women working in part-time jobs for which they are over-qualified. Reducing incentives for early retirement would improve labour supply incentives for older higher-skilled workers and help to stabilise pension spending amidst rising fiscal pressures due to ageing. Making the recently introduced centralised and transparent e-procurement platform mandatory for tenders at all levels of government and encouraging joint procurement initiatives of municipalities through financial incentives would raise spending efficiency and help to ensure fiscal sustainability.