Germany’s economy was set to rebound. But soaring energy prices have derailed Europe's biggest comeback

Europe's biggest economy was set for a rebound, but now it's being hammered by soaring energy costs caused by the Iran war, prompting the federal government to halve growth forecasts.

Germany's flagship fiscal stimulus package is in the spotlight as ministers scramble to cushion the impact of higher bills.

Before the war, the country had been powered by rising industrial orders, dropping inventories, and improving sentiment, thanks mainly to fiscal spending on defense and infrastructure.

But higher energy prices and supply chain risks are "spoiling the German growth party before it even started," said Carsten Brzeski, global head of macro research at ING.

The Federal Ministry for Economic Affairs and Energy this week slashed its growth forecast for 2026 to 0.5% from 1%, while its 2027 forecast was cut from 1.3% to 0.9%. Inflation is now projected to reach 2.7% this year and 2.8% the next.

Brzeski noted that industrial production was already "stuttering" before the war, sliding 0.3% month-on-month in February and printing flat on an annual basis.

But now the Iran conflict has sent business sentiment into freefall.

On Friday, the Ifo Institute for Economic Research's latest business climate index — a key temperature gauge of Germany's economic mood — dropped to 84.4 in April, down from 86.3 in March, its lowest level since May 2020, early in the Covid-19 pandemic.

Current assessments dipped from 86.7 to 85.4 month-on-month, while forward expectations tumbled from 85.9 to 83.3. Separately, the ZEW Indicator of Economic Sentiment slumped 16 points to -17.2 in April, its lowest reading since December 2022. The ZEW tracker tumbled from +58.3 in February to -0.5 points in March, indicating a rapid and deepening pessimism over the country's economic outlook.

"What we are seeing is that the German economy is hit hard by the Iran crisis," Clemens Fuest, president of Ifo, told CNBC on Friday. "Companies are telling us there is trouble ahead."

Germany remains one of Europe's largest net importers of energy, about 6% of which comes from the Middle East, according to ING analysis, while its so-called "energy-intensive" industries, which employ almost 1 million people, account for about 17% of industrial gross value added.

To cushion the energy shock — Brent crude prices have spiked almost 73% higher year-to-date — Germany's coalition government earlier this month agreed a two-month tax relief on petrol and diesel, worth about 1.6 billion euros ($1.87 billion). Katherina Reiche, federal minister for economic affairs and energy, said the federal government has acted "quickly and decisively to relieve the burden" of rising fuel costs.

Brzeski said the war has underscored Germany's heavy dependence on energy imports. "It is another painful reminder that simply shifting dependencies from one, Russia, to the other, the Middle East, is not a structural solution," he told CNBC via email.

But it's not just oil and gas supplies that are being disrupted by the conflict, according to Fuest.

"It's also intermediate products for the chemical industry. That has a broad impact; intermediate products for the construction industry, oil-based products. There is a risk that we get bottlenecks that can stop a lot of production," he told CNBC's "Squawk Box Europe."

Market watchers had hoped Germany's enormous fiscal stimulus package — which includes a 500 billion infrastructure investment fund for transport, digital and energy, and an increase on defense spending beyond its historic 1% of GDP limit — would turbo-charge its economy.

Fuest said the fiscal expansion remains a tailwind and "is now even more welcome." "If it wasn't there, the German economy would be shrinking," he said, singling out defense as one sector that continues to grow, aided by rising incoming orders.

Brent crude.

Brzeski said that the 200 billion-plus euros earmarked for spending on infrastructure and defense are still on track and will still reach the economy. But he cautioned that some will now likely be absorbed by higher energy prices and supply chain frictions, slowing overall progress.

"Overall the war in the Middle East is painfully delaying the German recovery but not yet derailing it," Brzeski added.

Niklas Garnadt, German economist at Goldman Sachs, said this week's growth downgrade does not "meaningfully affect" spending from the fiscal package.

"Under our current baseline for energy prices, we expect fiscal measures worth about 0.1% of GDP — or between 4 billion and 5 billion euros — to be directed towards addressing higher energy costs this year and next. But those measures should not replace spending from the fiscal package," Garnadt told CNBC via email.

Garnadt does not expect substantial additional measures on top of those already announced: the 1.6 billion euro fuel tax break and the tax benefits for one-off inflation bonuses, worth about 3 billion euros.

DAX.

Economy minister Reiche conceded that the fuel relief and other measures would not solve the deeper issues behind Germany's weak growth.

"We need a growing and competitive economy in addition to far-reaching structural reforms," Reiche said in a statement Wednesday announcing the growth outlook reduction. "Our companies need air to breathe again."

Brzeski said that higher energy prices are diverting the government's focus away from overdue structural reforms toward short-term support, calling it "not a very promising strategy."

"Germany urgently needs a better and more committed energy strategy, that ensures more autonomy and competitive prices," he added.

"Whether this is going all-in on renewables or rethinking nuclear, doesn't matter. What matters is that the government finally comes up with a long-term strategy."