German inflation unexpectedly drops to 2.6% in May as fuel discount takes effect, but ECB rate hike looms

Inflation surprise

Germany's annual inflation rate fell to 2.6% in May, down from 2.9% in April, according to preliminary data released by the Federal Statistical Office on Friday. Economists polled by Reuters had expected the rate to remain unchanged at 2.9%. Consumer prices declined by 0.2% compared to the previous month. The harmonised index of consumer prices, used for euro-area comparisons, rose 2.7% year-on-year and fell 0.1% from April.

Fuel discount drives the drop

The decline was driven largely by a government fuel tax cut that took effect on 1 May, reducing the tax on petrol and diesel. The Bundesbank estimates the measure will lower the inflation rate by roughly a quarter of a percentage point in both May and June. Data from North Rhine-Westphalia, Germany's most populous state, showed fuel prices fell 6.5% month-on-month, suggesting oil companies passed on most of the 17-cent-per-litre tax reduction.

The fuel discount is reaching drivers, at least largely.

The decline in crude oil prices compared to April and the fuel discount that has been in effect since the beginning of the month were decisive. The fuel discount has thus served its purpose.

Energy and food prices ease

Energy prices rose 6.6% year-on-year in May, a sharp slowdown from the 10.1% increase recorded in April. Food prices increased just 0.4%, down from 1.2% in April. Services, including restaurant visits and travel, rose 3.1%. Core inflation, which strips out food and energy, edged up to 2.5% from 2.3% in April. The Federal Cartel Office noted that crude oil prices also fell during the month amid hopes of de-escalation in the Middle East.

War and oil supply fears persist

The Iran war, which began in late February with US and Israeli military action, has driven energy prices higher. Iran has been blocking the Strait of Hormuz for weeks, through which roughly one-fifth of global crude oil and liquefied gas normally passes. The German Council of Economic Experts expects an average inflation rate of 3.0% for 2026, but warns it could reach 3.5% if oil and LNG supply remain constrained. The council forecasts German GDP growth of just 0.5% this year.

ECB rate hike seen as certain

The European Central Bank is widely expected to raise interest rates by 0.25 percentage points at its meeting on 11 June, which would be the first hike since September 2023. ECB Executive Board member Isabel Schnabel said a June rate increase is necessary from today's perspective. Bundesbank President Joachim Nagel expressed a similar view, and even traditionally dovish Greek central bank chief Yannis Stournaras told Bloomberg that a hike is likely needed to preserve the ECB's credibility. Chief Economist Philip Lane indicated the bank will have to raise its inflation forecast, noting oil prices are likely to remain elevated for longer than assumed in March.

From today's perspective, I consider a rate hike in June to be necessary.

To preserve the credibility of the ECB and our ability to respond, we will probably have to raise rates in June.

Outlook for consumers

Economists expect companies to gradually pass higher energy, production, and transport costs on to customers, pushing up food and services prices further. The Ifo Institute's price expectations barometer fell slightly to 30.3 points in May from 31.3 in April, indicating somewhat fewer firms plan to raise prices. The temporary fuel discount is set to expire at the end of June, though Berenberg Bank chief economist Holger Schmieding suggested that further declines in crude oil prices could allow the government to extend the discount at a lower rate or let it expire despite the summer travel season.