But the Europhile announced his shock resignation in a statement at the party headquarters in Berlin this evening after his popularity plummeted.
Mr Schulz stood down as President of the European Parliamant to challenge Mrs Merkel in last year’s national elections.
Ms Nahles, a plain-speaking 47-year-old former labour minister with a left-wing slant and strong oratory skills, is frontrunner and would become the first female leader in the party’s 154-year history.
But expectations that she would take over with immediate effect on a caretaker basis until a party conference triggered resistance as it breaches party procedure.
Mr Schulz’s resignation comes after a week of turmoil within the SPD.
He leaves a party in a state of deep division over the coalition deal and the division of ministerial posts and also facing a disastrous slump in opinion polls.
SPD chiefs have desperately tried to convince the party’s 464,000 members to back the deal in a ballot on which Mrs Merkel’s fourth term hangs.
But many SPD members have grave misgivings about sharing power with Mrs Merkel again and if members reject the coalition deal in a March 4 ballot a new election looks the most likely option.
Mr Schulz hinted last week he would quit to allow the party to regroup.
The change of leadership comes as Mrs Merkel becomes increasingly anxious to get a government in place and end more than four months of political limbo which has hampered decision-making in Germany, Europe’s largest economy.
The lack of leadership has caused concern among partners in the European Union which looks to Berlin for leadership in facing challenges from eurozone reform to Brexit.
Mr Schulz, who originally strongly opposed another tie-up with the conservatives only to become one of its leading advocates, has lost political credibility but hopes his decision to step aside will now encourage SPD members to back the coalition deal.