Compared with our previous forecast, we now expect more severe tariff effects and lower inflation, which mostly reflect the appreciation of the euro.  We continue to expect eurozone growth will remain subdued this year, at about 0.8%. While uncertainty and tariffs reduce demand over the short term, growth will likely accelerate substantially to 1.1% in 2026 and 1.4% in 2027. This acceleration will benefit from strong private sector balance sheets, expansive fiscal policies, and lower key interest rates.

We revised our growth forecasts, which now consider U.S. tariffs of 50% on steel and aluminum imports, compared with the previously expected 25%. Other assumptions remain unchanged, with 25% tariffs on pharmaceutical and car imports, in addition to a universal 10% tariff.

The effects of a 50% tariff on steel and aluminum imports would be more severe in Italy and Germany than in other European countries, although the overall effects would remain within our established forecast range. We note that these tariff assumptions could change quickly, as the deadline for trade negotiations approaches.

The European economy has largely rebalanced, following the COVID-19 pandemic and the outbreak of the Russia-Ukraine war.  The labor market remains robust ahead of a significant increase in public spending on infrastructure and defense. Additionally, the euro appreciated faster than anticipated, mainly due to investor sentiment rather than foreign exchange fundamentals. This, combined with lower oil prices between April and early June, led us to revise our headline inflation forecast for 2026 downward to 1.7%, from 1.9%.

However, we expect core inflation will remain close to the ECB's 2% target. Barring external shocks, the ECB is therefore unlikely to announce further rate cuts.

Downside risks to growth persist.  These are primarily linked to U.S.-EU trade negotiations, potential spillovers from financial markets, geopolitical developments, and uncertainties about European countries' fiscal plans, which remain inconcrete.

Inflation risks result from upside pressures, such as countertariffs, fiscal stimulus coinciding with labor market bottlenecks, and geopolitical developments impairing oil markets. Downside risks include trade redirection to Europe and another disorderly appreciation of the exchange rate.

We note that our oil price assumptions, which predate the escalation in the Middle East, assume the a barrel of Brent crude oil will trade at $65 for the rest of 2025 and $70 in 2026. If the Brent crude oil price sustainably exceeded these assumptions by 10%, we could revise our inflation forecast for 2026 upward to 1.9%-2.0% from 1.7%.

Recent Trade Volatility Conceals Increasing Domestic Demand

Eurozone GDP rose significantly during the first quarter of 2025.  It expanded by 0.6% quarter over quarter, which translates into an annualized rate of 2.5%. Slightly less than half of this growth resulted from net exports, with two-thirds of these originating from Ireland.

The acceleration in GDP growth mostly reflected the front-running of pharmaceutical exports to the U.S. ahead of potential tariffs (see chart 1). These trade flows started to reverse in April 2025, with the eurozone economy potentially contracting in the second quarter.

Chart 1

That said, export volatility does not fully capture developments in Europe.  Domestic demand, excluding inventories, contributed more than net exports to GDP growth in the first quarter. Household investment rose 0.6% and consumer spending increased by 0.2% quarter over quarter. The quarter-over-quarter rise in business investment was even more pronounced at 2.6%, which corresponds to an annualized rate of 11%.

The strengthening domestic demand--which benefits from large private savings, rising real incomes, and lower interest rates--aligns with our base-case expectations.  However, we thought the current recovery in business investment would only materialize in 2026, because we assumed many businesses would wait for clarity on tariffs before making any decisions.

We have considered this early rebound in our revised forecasts by lifting business investment growth prospects for 2025 but lowering them for 2026, as the reference point is higher. Underlying factors that support business investment include:

Decreasing negative output gap:  Business investment in Europe remains about 10% below pre-pandemic levels and has lagged other demand components since the beginning of the pandemic (see chart 2). Manufacturing capacity utilization has increased steadily over the past nine months.

Rebalancing after previous shocks:  Although tariff-related uncertainty has not peaked yet, uncertainty about the Russia-Ukraine war has diminished. Terms of trade, which deteriorated sharply in 2022 due to sanctions on gas imports from Russia, have also normalized. So far, the effects of trade uncertainty on the European economy are less pronounced than war-related uncertainty (see chart 3).

Expected demand increase:  Anticipated higher public spending on infrastructure and defense is supporting investment.

Monetary policy transmission:  Past interest rate cuts may already boost domestic demand, especially given large savings buffers. The current lending capacity of households and non-financial corporations is equivalent to 5% of GDP.

Tariff adaptation:  While it is still too early to tell, companies could invest to adapt their supply chain to the new tariffs environment.

Chart 2

Chart 3

Public Spending Promises Remain Vague

European growth will accelerate above its potential over the forecast horizon.  We expect that fiscal spending in Germany will increase to about €1 trillion over the next 12 years and that European defense spending will rise to about €800 billion over the next four years.

These expectations, which we have factored in our base-case scenario since March 2025, are based on assumptions about timing, execution, price, and multiplier effects. Information that became available after March has not materially changed our initial assumptions.

Germany's fiscal stimulus package has been approved by the parliament, but concrete projects and timelines are still to be confirmed. As a result, multiplier effects on the German economy and likely spillovers to other European countries largely remain technical assumptions at this stage. Yet we note that spillovers to Eastern European countries could be substantial (see chart 4).

Chart 4

A potential increase in defense spending does not render our previous assumptions obsolete.  For example, at its summit in The Hague, the North Atlantic Treaty Organization (NATO) will likely raise the spending target to 5% over the next ten years. NATO members have already expressed their willingness to do so. It is likely, however, that not all countries will increase spending at the same pace.

Additionally, the EU implemented a temporary fiscal framework flexibility that allows member states to exclude defense spending of up to 1.5% of GDP from fiscal rules for four years, starting in 2025. The breakdown of military spending and hence its effect on the European economy remain unclear.

For example, if Germany aims to catch up with Poland's or France's defense spending, it will need to increase spending on military personnel and equipment (see chart 5). The multiplier effects of these two types of defense spending on Germany are different, especially if military equipment purchases are made abroad.

Chart 5

Notably, the "security action for Europe" loan of €150 billion caps the purchase of foreign components at 35% of total costs. Even so, the defense package, which was endorsed by EU member states in May 2025 to boost European defense capabilities, will cover only a minor part of the European defense effort.

However, the EU's ReArm program, which aims to expand European defense industrial production capacity and foster an EU-wide market for defense equipment, could strengthen the multiplier effects of military spending over the medium term. Since Russia's invasion of Ukraine, European production of weapons and ammunition has increased by 60%, with the highest contributions coming from Germany and France.

The Labor Market Goes From Strength To Strength

The number of jobs in the European economy increased by 3,000 in first-quarter 2025.  Employment reached a new record high, with the unemployment rate at a record low of 6.2%. This was despite a decline in job openings to 2.4% of the labor force. The steady rise in employment since 2023, amid near-stagnant GDP growth, is an anomaly that we expect will correct at some point.

So far, the labor market adjustment appears positive. GDP growth outpaced employment growth at the start of 2025. This reduced the unusually large productivity gap (see chart 6) and unit labor costs.

Chart 6

When investigating the reasons for the current decorrelation between job numbers and business needs, we found that employment growth focuses on specific regions.  Of the 7.2 million net jobs added in the eurozone since 2019, half originated in Spain and France. Germany lagged, mainly due to job losses in manufacturing and construction.

Most new jobs were added in the information and communication technologies sector, with Germany taking the lead. This was followed by professional and scientific services, health, and education. Manufacturing jobs declined across Europe, with some of them having been relocated to Italy and Spain (see table 1).

Of the new jobs, 57% are held by employees aged at least 50 and 54% are held by women. The balance between public and private sector job creation varies by country.

Table 1

The Inflation Outlook Is Blurred

While inflation has moderated recently, the interplay of foreign exchange and oil price movements, trade negotiations, and fiscal stimulus coinciding with tight labor market conditions clouds the inflation outlook for the coming years.

Inflation continued to ease in May 2025.  Year over year, it declined by 0.3 percentage points to a headline rate of 1.9% and a core inflation rate of 2.3% (see chart 7). This moderation is primarily due to a 5% drop in energy prices that reflects lower oil prices between April and early June and the rapid appreciation of the euro exchange rate.

Chart 7

Additionally, service inflation softened by 0.8 percentage points to 3.2%, influenced by the reversal of a seasonal peak over Easter and the slowing wage growth. Negotiated wages decelerated significantly to 2.4% in first-quarter 2025, from 4.1% in fourth-quarter 2024. Accordingly, the correlation between real wage growth and productivity gains increased.

These trends largely aligned with our inflation forecast for 2026.  They prompted only a modest downward revision of 0.2 percentage points that resulted from new oil price projections and the faster-than-anticipated appreciation of the euro.

That said, our medium-term inflation outlook remains broadly unchanged. We anticipate inflation will rise again in 2027, primarily due to fiscal stimulus measures that will necessitate more hiring amid a persistently tight labor market and upward wage pressures. Additionally, tariff adaptation will likely push producer prices up over the medium term.

Our inflation outlook is subject to several external risks

Higher-for-longer euro exchange rate:  The rapid appreciation of the euro was more a result of investor sentiment than economic fundamentals. Based on current estimates, the euro is about 10 cents stronger against the U.S. dollar than is justified by the interest rate differential (see chart 8).

Chart 8

We expect that the euro will continue to appreciate modestly over the forecast horizon and that it will be more in line with the interest rate differential. This is because the Federal Reserve will begin to cut rates later this year, while policy premia could diminish, especially if the EU and the U.S. reach a trade deal.

Yet further policy developments could change the course of these forecasts. For example, prolonged trade negotiations could strengthen the euro further. We note that our short-term euro forecasts carry a significant degree of uncertainty, not least since it is unclear whether the euro has established itself as a safe haven currency in the current environment.

Futile trade negotiations:  If the EU and the U.S. fail to reach a trade agreement and if the EU's proposed countertariffs of €95 billion are implemented, inflation in Europe could increase by 0.2%-0.3% in 2026. Risks could increase if tariff negotiations escalate.

Trade redirection to Europe:  If access to the U.S. market becomes more restricted, a potential rerouting of Chinese and European goods to the European single market could exert downward pressure on consumer prices. Although this risk is currently not materializing (see chart 9), we cannot dismiss it just yet, given the early stage of trade discussions.

Chart 9

The ECB Takes A Break From Cutting Rates

The ECB's president, Christine Lagarde, signaled a pause in rate cuts.  Eight cuts over the course of 12 months reduced the main policy rate to 2.0%. During a press conference, Ms. Lagarde stated that the monetary policy is now "in a good place" to navigate the current environment.

Markets have interpreted this as a potential end to the rate-cutting cycle, with less than 10% probability priced in for a cut in July and less than 50% for a cut in September. This aligns with our expectations.

We continue to believe the ECB's current rate cycle has likely bottomed out at 2%.  This is because of recovering domestic demand, strong labor markets, and solid balance sheets. Considering fiscal stimulus packages and persistent labor market tightness, the ECB may need to raise rates again, potentially in early 2027, to keep inflation on target.

If inflation decreases below the target for a short term--for example due to lower energy prices and an appreciation of the euro--we expect the ECB would not take immediate rate actions. Further rate cuts could occur if external conditions deteriorate, which will primarily depend on the outcome of the trade negotiations between the EU and the U.S.

Quantitative tightening continued and steepened the yield curve (see chart 10).  The ECB's quantitative tightening includes the reimbursement of long-term refinancing operations for banks and the non-reinvestment of maturing bonds held for monetary policy purposes.

Chart 10

Excess liquidity held by banks declined to €2.8 trillion from a peak of €4.7 trillion over the past three years. This remains consistent with our assumption that excess reserves could settle at about €1.7 trillion by the end of 2026.

We expect the ECB will provide guidance on the pace of quantitative tightening and possibly detail its desired level for excess liquidity during its strategy review, which will likely occur later this year.

The Outcome Of Trade Negotiations Is Key

The final terms of the tariff deal between the EU and the U.S. could significantly alter our short-term baseline forecasts.  Current U.S. tariffs--including 10% on all manufactured goods, 25% on cars, and 50% on steel and aluminum--will reduce eurozone GDP by 0.3%. In comparison, the tariffs announced on April 2, 2025--20% on all goods, in addition to section 232 tariffs--would have had a more pronounced effect on GDP growth.

We consider in our baseline assumptions U.S. tariffs of 10% on all goods, 25% on cars and pharmaceuticals, and 50% on steel and aluminum. If the U.S. imposes universal tariffs of 50%, as the U.S. president recently suggested, eurozone GDP would decrease by 1.1% (see chart 11).

In a best-case scenario that would only include a 10% universal tariff, eurozone GDP would decline by a quarter point of GDP. We note that the length of the period over which the tariffs would apply also plays a role.

Chart 11

U.S. tariffs affect European countries unevenly, reflecting their export specializations.  For example, Germany relies heavily on car exports to the U.S., while Italy is a large steel exporter. In contrast, France and Spain are less exposed to tariff effects.

Another key uncertainty is whether pharmaceutical products will be targeted specifically. Ireland, Belgium, and Switzerland are significant pharmaceutical exporters to the U.S. (see chart 12).

Chart 12

The possibility of EU countertariffs adds another layer of uncertainty.  The EU's proposed countertariffs would target about one-third of goods imported from the U.S. Assuming typical pass-through effects, these measures could raise consumer prices in Europe by 0.2%-0.3%. This would have a marginal effect on consumer spending, especially considering households' large savings buffers.

The EU sees countertariffs as a last resort, especially countermeasures on services. Yet the complexity of trade negotiations--with taxes and regulatory aspects also under discussion--means that all outcomes are possible at this stage, including more delays in reaching an agreement. We continue to closely monitor these developments.

Beyond EU-U.S. trade tensions, several other downside risks to growth persist. These include potential spillovers from financial markets, geopolitical escalations and their consequences on commodity prices, transportation routes and supply chains, and uncertainties about the implementation of fiscal plans in Europe.

Table 2

Related Research

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• Economic Outlook Eurozone Q2 2025: A World In Limbo, March 25, 2025
• 2024: Two recovery anomalies; 2025: Three policy pivots, Dec. 18, 2024
• What An Acceleration Of Quantitative Tightening Could Mean For Eurozone Banks, Sept. 13, 2023