Germany is reigniting cautious optimism in Europe’s economy

Stay informed with free updates

Simply sign up to the German economy myFT Digest — delivered directly to your inbox.

Germany’s closely followed Ifo index of business sentiment fell to its lowest level at the end of 2025 since the spring. “The year is ending without any sense of optimism,” the Ifo institute noted succinctly. 

But to some economists, this feeling of gloom in the Eurozone’s largest economy is misplaced — at least, in part. Not only did the single currency zone prove more economically resilient than expected in 2025, but additional growth drivers are also poised to kick in over the coming 12 months, which have the potential to lift the outlook. 

The key one is the impact of German fiscal policy. The country is set to inject stimulus into the economy even as the benefits of European Central Bank interest rate cuts continue to feed through. Falling inflation and ongoing real-terms household income growth should support the outlook, analysts add. 

“We expect growth to accelerate in the course of this year,” says economist Bert Colijn at ING bank. 

The global environment will remain challenging because of competition from China, US trade tensions and a strong euro, he says, but there is an optimistic economic case resting on domestic factors.

Cautious optimism about the Eurozone lifted some of the region’s key equity indices in 2025 — including the German Dax index of 40 blue-chip companies, which rose 23 per cent vs the S&P 500’s 18 per cent.

Forecasts from the ECB released just before the end-of-year break pointed to a solid growth performance in the coming two years. Growth in Eurozone GDP is predicted to be 1.2 per cent in 2026 and 1.4 per cent in 2027 and 2028 — similar to last year’s expansion. 

Business investment will rise in 2026-2028, the ECB forecasts, borne higher by increasing profit growth and relatively low interest rates. 

The biggest shift comes down to budget policy, which is expected to be stimulative overall because of the decision by the government of Chancellor Friedrich Merz to loosen its self-imposed budgetary strictures and invest in defence and infrastructure. 

The German budget deficit is set to widen from 3.1 per cent of GDP in 2025 to 4 per cent in 2026, according to European Commission projections.

More public spending in the region’s biggest economy will have knock-on effects for businesses and consumers elsewhere in the currency zone. The peak of the impact on the single currency area will be felt in 2026, the ECB projections suggest, with an overall Eurozone fiscal loosening of 0.3 percentage points. This comes even as some Euro area countries make efforts to rein in public debt — among them France and Italy.

Household sentiment remains subdued, with a European Commission index of optimism dipping in December and still hovering below pre-pandemic levels. The household savings ratio remains high at over 15 per cent of disposable income. 

But unemployment is still near record lows, real wages are growing, and lending growth is up, points out Claus Vistesen at Pantheon Macroeconomics. “We think Eurozone households’ spending will continue to grow modestly in coming quarters.” 

At the same time, growth threats remain manifold. Among them are the risk of fresh political tensions with the US, and the war between Russia and Ukraine. 

A renewed Chinese push for export growth poses particularly acute challenges for German GDP, Goldman Sachs analysts warn, with slightly less pronounced effects for Italy, France and Spain. 

As a recent global FT survey showed, economists expect the US to extend its productivity lead over Europe thanks to AI investments. Meanwhile progress on deepening the EU single market and bolstering the region’s economic dynamism is patchy. 

And while Germany may have space for a €1tn debt-funded spending drive on infrastructure and defence, the economy’s overall performance remains tepid. The Bundesbank in December lowered its 2026 German growth forecast by 0.1 percentage points to 0.6 per cent, while raising its 2027 prediction by the same amount to 1.3 per cent.

Nevertheless lower energy costs should help the region’s manufacturing powerhouses, and inflation now appears to have been decisively quelled, leading to ECB predictions that policy is in a “good place”. It forecasts annual inflation of 1.9 per cent in 2026.

Then on top of that comes the fiscal policy shift in its biggest economy. 

“The biggest factor that makes 2026 better is that we will likely see a private sector response to the German fiscal stimulus — consumers and businesses feeling better and spending more money,” says Holger Schmieding at Berenberg Bank.

Low interest rates will have even more far-reaching effects across the Eurozone, stimulating investment and residential construction, he adds. “It is not just a German fiscal story.”