The Euro Area economy closed Q1 on a positive note but enters Q2 facing unprecedented uncertainty. Business activity improved modestly in March, with the composite Purchasing Managers’ Index (PMI) reaching a value of 50.9. The Services PMI stood at 51.0, with the sector remaining the main driver of output growth in the region. More notably, factory output also improved with manufacturing PMI hitting 48.6, its highest value in over two years. US companies stockpiling European goods ahead of tariffs, and improved production expectations fueled by the promise of increased defense spending across Europe are key reasons behind the recent improvement in manufacturing sentiment. As a result, ongoing improvements in more timely business survey data suggest growth to have gained some momentum in early 2025. Entering Q2 though, the clarity on the exact tariff of 20% the US will impose on most EU products announced on April 3rd has not reduced the levels to uncertainty. As EA exports to the US account for almost 4% of the bloc’s GDP, we estimate tariffs to have a negative impact on the EA’s economy. Germany, France and Italy could lose around 0.2 percentage points (pp) from their 2025 output growth. Smaller economies, like Ireland and Slovakia are also expected to be more severely hit, given their large trade volumes with the US, although this will not have a substantial impact on the bloc’s overall GDP growth number. Looking further into 2026, forecasting becomes ever more challenging also due to our limited knowledge on both the duration of current tariffs and Europe’s reaction to the existing ones. There are also upside risks that could cushion the tariffs’ negative impact on growth. EU’s defense spending surge and Germany’s announced fiscal stimulus, a more accommodative monetary policy from the ECB, and a resilient labor market that will sustain private consumption and spending can help mitigate the impact of US tariffs on the bloc’s economy. Last, we observe an increase in M&A activity and European equities. We cannot assess whether this will lead to the size of private equity markets the continent needs, but it is certainly welcome. On average and given that the upside risks (opportunities) are back loaded, we downgrade marginally our GDP growth forecasts for 2025, now expecting the EA to grow by 0.8% year-on-year (from 0.9% in March), while the economic rebound in 2026 is now projected to come in weaker than expected, with growth averaging 1.1% (from 1.2% a month ago).
Inflation reaches its lowest point in three years, but risks cloud the inflation outlook. Annual inflation in the EA declined to 2.2% in March, down from 2.3% in February. The decline was driven by another notable drop in annual energy prices, while food inflation increased from 2.7% to 2.9% year-on-year. Core inflation also decreased to 2.5%, with services inflation the main driver behind this month’s decline. Until now, inflation has been steadily getting closer to the ECB’s medium-term objective of 2%. However, April’s tariff shock might impact the disinflation process in both directions. On the one hand, the possibility of third countries (particularly China) redirecting capacity to Europe would put downward pressure on domestic prices. On the other hand, the threat of retaliation would put upward pressures on prices. The uncertainty that still remains on both policies and reactions also complicates the transmission of these effects. We project overall inflation to average 2.3% in 2025 before falling to 1.9% in 2026, while core inflation is now estimated to average 2.3% and 1.9% in 2025 and 2026, respectively. Nonetheless, as our forecasts are subject to large revisions, we urge readers to exercise caution when interpreting these numbers.
A rate cut in April now appears the most likely scenario for the ECB. Last month the European Central Bank (ECB) lowered its key rates by 25 basis points (bp), bringing its main policy rate (i.e., deposit) at 2.50%. In March’s Press Conference, it was noted that the disinflation process is well on track and that monetary policy is becoming meaningfully less restrictive, hinting that the Bank could even pause rates in their next meeting on April 17. We think this is unlikely now as trade wars have worsened the EA’s already modest growth outlook. As a result, we make no changes to our policy rate forecasts, expecting another 25bp cut in the bank’s effort to offset the impact of trade policy uncertainty. Looking further ahead, as disinflationary pressures mount, the need for extra cuts reduces. We revise upwards the ECB’s terminal rate for 2025, now expecting the ECB to cut one more time in 2025, leaving its main policy rate at 2.00% (from 1.75% we had a month ago.)
The labor market remains the bloc’s strongest economic pillar. The region’s unemployment rate declined in February to 6.1%, the lowest point in the bloc’s 24-year history. This came in as a very positive surprise, since employment expectations in the bloc had become pessimistic in recent months. We think this is unlikely to translate into sudden spikes in the region’s unemployment rate, though EA business leaders point to scaling back hiring plans in the near future in response to global uncertainty. We also note that the US tariffs are likely to have a limited impact on unemployment within the forecast horizon. More importantly, a resilient labor market adds to the possibility that private consumption will continue to be a key growth driver for the Euro Area.
There are downside risks that can be economically significant for the Euro Area in the very near-term:
- All eyes on the EU’s response to US tariffs. Latest news from Brussels suggests the EU could try to strike a zero-for-zero trade deal with the US that would cover industrial goods critical for the European economy such as cars, chemicals and machinery. This remains the main objective of EU trade policy. However, at the same time, the EU needs to preserve credibility in its trade policy instruments by using them in proportional retaliation. The European Commission is finalizing the list of US goods that it will target in response to Trump’s 25% tariffs on aluminum and steel as well as on the retaliatory measures it must adopt against the more recent car and reciprocal duties. The EC could also activate its Anti-Coercion Instrument (ACI), a “trade bazooka” that has never been tested, which would allow the region to target US service industries, put import/export restrictions or limit access of US firms to the European market, ultimately dragging the two regions into a full-fledged trade war. There are risks both in doing nothing (or little) as well as in doing too much (like activating the ACI).
- Financial stability risks. The economic policies applied in the US have triggered a dollar depreciation (despite tariffs that would normally cause an appreciation) and an economically significant drop in US treasuries, the world’s safest asset. Next to that, world stock markets have seen unprecedent drops in the space of days that are a cause of great concern to businesses. If this translates into a drop in overall confidence, with doubts being cast even on the Fed’s global role of providing liquidity in moments of crisis, it can generate a financial crisis of great proportions. This remains a tail risk, but the speed of movement we have seen, especially in the first two weeks of April, is worrying.
- Political turmoil in France continues: France’s biggest far-right political party, National Rally (RN), threatens to topple (again) Bayrou’s minority government, just four months after taking down Michel Barnier. The threat comes as a response to Marie Le Pen’s, RN’s political leader, conviction of embezzlement and her sentence to a five-year ban from running for president. A new government collapse would throw the country into a new period of political turmoil, further reducing the already weak business and consumer confidence. Mounting fiscal pressures, tariffs, tax hikes and weak business sentiment are already weighing on the country’s economy, which we already see growing below trend or the EA’s average in 2025 and 2026.
The Euro Area economy closed Q1 on a positive note but enters Q2 facing unprecedented uncertainty. Business activity improved modestly in March, with the composite Purchasing Managers’ Index (PMI) reaching a value of 50.9. The Services PMI stood at 51.0, with the sector remaining the main driver of output growth in the region. More notably, factory output also improved with manufacturing PMI hitting 48.6, its highest value in over two years. US companies stockpiling European goods ahead of tariffs, and improved production expectations fueled by the promise of increased defense spending across Europe are key reasons behind the recent improvement in manufacturing sentiment. As a result, ongoing improvements in more timely business survey data suggest growth to have gained some momentum in early 2025. Entering Q2 though, the clarity on the exact tariff of 20% the US will impose on most EU products announced on April 3rd has not reduced the levels to uncertainty. As EA exports to the US account for almost 4% of the bloc’s GDP, we estimate tariffs to have a negative impact on the EA’s economy. Germany, France and Italy could lose around 0.2 percentage points (pp) from their 2025 output growth. Smaller economies, like Ireland and Slovakia are also expected to be more severely hit, given their large trade volumes with the US, although this will not have a substantial impact on the bloc’s overall GDP growth number. Looking further into 2026, forecasting becomes ever more challenging also due to our limited knowledge on both the duration of current tariffs and Europe’s reaction to the existing ones. There are also upside risks that could cushion the tariffs’ negative impact on growth. EU’s defense spending surge and Germany’s announced fiscal stimulus, a more accommodative monetary policy from the ECB, and a resilient labor market that will sustain private consumption and spending can help mitigate the impact of US tariffs on the bloc’s economy. Last, we observe an increase in M&A activity and European equities. We cannot assess whether this will lead to the size of private equity markets the continent needs, but it is certainly welcome. On average and given that the upside risks (opportunities) are back loaded, we downgrade marginally our GDP growth forecasts for 2025, now expecting the EA to grow by 0.8% year-on-year (from 0.9% in March), while the economic rebound in 2026 is now projected to come in weaker than expected, with growth averaging 1.1% (from 1.2% a month ago).
Inflation reaches its lowest point in three years, but risks cloud the inflation outlook. Annual inflation in the EA declined to 2.2% in March, down from 2.3% in February. The decline was driven by another notable drop in annual energy prices, while food inflation increased from 2.7% to 2.9% year-on-year. Core inflation also decreased to 2.5%, with services inflation the main driver behind this month’s decline. Until now, inflation has been steadily getting closer to the ECB’s medium-term objective of 2%. However, April’s tariff shock might impact the disinflation process in both directions. On the one hand, the possibility of third countries (particularly China) redirecting capacity to Europe would put downward pressure on domestic prices. On the other hand, the threat of retaliation would put upward pressures on prices. The uncertainty that still remains on both policies and reactions also complicates the transmission of these effects. We project overall inflation to average 2.3% in 2025 before falling to 1.9% in 2026, while core inflation is now estimated to average 2.3% and 1.9% in 2025 and 2026, respectively. Nonetheless, as our forecasts are subject to large revisions, we urge readers to exercise caution when interpreting these numbers.
A rate cut in April now appears the most likely scenario for the ECB. Last month the European Central Bank (ECB) lowered its key rates by 25 basis points (bp), bringing its main policy rate (i.e., deposit) at 2.50%. In March’s Press Conference, it was noted that the disinflation process is well on track and that monetary policy is becoming meaningfully less restrictive, hinting that the Bank could even pause rates in their next meeting on April 17. We think this is unlikely now as trade wars have worsened the EA’s already modest growth outlook. As a result, we make no changes to our policy rate forecasts, expecting another 25bp cut in the bank’s effort to offset the impact of trade policy uncertainty. Looking further ahead, as disinflationary pressures mount, the need for extra cuts reduces. We revise upwards the ECB’s terminal rate for 2025, now expecting the ECB to cut one more time in 2025, leaving its main policy rate at 2.00% (from 1.75% we had a month ago.)
The labor market remains the bloc’s strongest economic pillar. The region’s unemployment rate declined in February to 6.1%, the lowest point in the bloc’s 24-year history. This came in as a very positive surprise, since employment expectations in the bloc had become pessimistic in recent months. We think this is unlikely to translate into sudden spikes in the region’s unemployment rate, though EA business leaders point to scaling back hiring plans in the near future in response to global uncertainty. We also note that the US tariffs are likely to have a limited impact on unemployment within the forecast horizon. More importantly, a resilient labor market adds to the possibility that private consumption will continue to be a key growth driver for the Euro Area.
There are downside risks that can be economically significant for the Euro Area in the very near-term:
- All eyes on the EU’s response to US tariffs. Latest news from Brussels suggests the EU could try to strike a zero-for-zero trade deal with the US that would cover industrial goods critical for the European economy such as cars, chemicals and machinery. This remains the main objective of EU trade policy. However, at the same time, the EU needs to preserve credibility in its trade policy instruments by using them in proportional retaliation. The European Commission is finalizing the list of US goods that it will target in response to Trump’s 25% tariffs on aluminum and steel as well as on the retaliatory measures it must adopt against the more recent car and reciprocal duties. The EC could also activate its Anti-Coercion Instrument (ACI), a “trade bazooka” that has never been tested, which would allow the region to target US service industries, put import/export restrictions or limit access of US firms to the European market, ultimately dragging the two regions into a full-fledged trade war. There are risks both in doing nothing (or little) as well as in doing too much (like activating the ACI).
- Financial stability risks. The economic policies applied in the US have triggered a dollar depreciation (despite tariffs that would normally cause an appreciation) and an economically significant drop in US treasuries, the world’s safest asset. Next to that, world stock markets have seen unprecedent drops in the space of days that are a cause of great concern to businesses. If this translates into a drop in overall confidence, with doubts being cast even on the Fed’s global role of providing liquidity in moments of crisis, it can generate a financial crisis of great proportions. This remains a tail risk, but the speed of movement we have seen, especially in the first two weeks of April, is worrying.
- Political turmoil in France continues: France’s biggest far-right political party, National Rally (RN), threatens to topple (again) Bayrou’s minority government, just four months after taking down Michel Barnier. The threat comes as a response to Marie Le Pen’s, RN’s political leader, conviction of embezzlement and her sentence to a five-year ban from running for president. A new government collapse would throw the country into a new period of political turmoil, further reducing the already weak business and consumer confidence. Mounting fiscal pressures, tariffs, tax hikes and weak business sentiment are already weighing on the country’s economy, which we already see growing below trend or the EA’s average in 2025 and 2026.
For more resources on the European economy, please see our monthly Economy Watch report and annual long-term outlook (December 2024).
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