As risks loom, growth in the Euro Area will remain lackluster in the short run.
Business activity to grow marginally in H1 2025. Activity in the private sector in the Euro Area (EA) continued to expand marginally according to February’s Purchasing Managers’ Index (PMI) data. Factory output in the region improved to 47.6, increasing for the third month in a row and reaching its highest point in two years. Separate data from the European Commission showed the rise in sentiment was driven mainly by improvements in production expectations and export orders. Contrary to manufacturing, activity growth in services decelerated in February, falling from 51.3 to 50.6. The drop was largely due to services sentiment in France which took a strong hit following the announcement of major tax hikes (and spending cuts) for 2025. On the demand side, consumer confidence increased further suggesting private spending will remain supportive to economic activity in Q1. The export outlook has also turned less favorable in anticipation of the European Commission’s imposing retaliatory tariffs on US imports worth nearly 26 billion euros. Summing up, following weak growth of 0.1% in Q4 2024, the EA economy is projected to expand at around 0.2% in Q1 and H1 2025, before increasing by 0.3% in the second half of the year. In annual terms, we still see the region growing by 0.9% in 2025, but we downgrade slightly our forecasts for 2026, now expecting output to grow by 1.2%.
Headline inflation declines for the first time in five months. Annual inflation in the EA declined to 2.4% in February, down from 2.5% in January. The decline was solely driven by a significant fall in annual energy prices, while food inflation increased from 2.3% to 2.7% year-on-year. Core inflation, also decreased to 2.6% reaching its lowest value in three years. Yearly goods inflation increased marginally from 0.5% to 0.6%, while services inflation decreased from 4.0% to 3.8% year-on-year. Looking ahead, headline inflation is well on track to continue falling in 2025 as domestic demand, despite signs of gaining momentum, will remain subdued by normal (pre-COVID) standards.
The ECB cut rates to 2.5% but the pace of easing becomes more uncertain. On March 6th, the European Central Bank (ECB) lowered its key rates by another 25 basis points (bp), bringing its main policy rate (i.e., deposit) at 2.5%. Looking ahead, the monetary path the bank is going to follow has become less clear. In her recent speech in Frankfurt, Christine Lagarde, the ECB’s president highlighted that pre-committing to a monetary path in an environment of multiple, highly uncertain and persistent “two-sided” shocks could hurt “the bank’s agility to react appropriately”. We continue to believe that the ECB will resume its easing cycle because the reasons that explain it are still there, namely declining corporate profits and wages, renewed prospects of trade fragmentation and an economy suffering from cyclical challenges and persisting structural weaknesses. As a result, we make no changes to our monetary projections expecting the bank to lower rates anywhere from two to three more times in 2025, bringing its main policy rate to as low as 1.75% by the end of the year. However, as we will discuss further down, there are also important upside risks that might lead us to change our growth forecast as well as the ECB’s policy path.
Unemployment remains at an all-time low, but employment expectations turn more pessimistic. The European labor market remains resilient. Recent data show that the unemployment rate continues at the all-time low levels of 6.3%. Employment expectations, however, declined in February with the indicator falling from 98.5 in January to 97.0, suggesting EA business leaders intend to scale back on their hiring plans in the region. Nonetheless, the Euro Area labor market should remain robust in the year ahead. We still see unemployment rate stabilizing at around 6.5% in 2025 and employment rising, though more slowly than in 2023 and 2024.
There are two upside risks that can be economically significant, and one downside risk that is, by comparison, less impactful.
- The EU rearms. European Commission president von der Leyen announced the possible mobilization of €800 billion to boost defense spending over a period of four years. The intention is to have €650 billion in member states increased defense spending, and the rest €150 billion to be provided in the form of European loans to countries. This will provide, when implemented, a considerable fiscal stimulus across all member states and increase significantly aggregate demand that will in turn increase growth in the short run.
- Germany’s defense spending plan: Germany’s chancellor-to-be, Friedrich Merz, with its likely coalition partner, SPD, announced earlier in March a plan to pump hundreds of billions of euros (between €500 and €800 billion) to be dedicated to both defense and infrastructure. In order to do that, they proposed to reform the country’s debt brake, which limits spending to 0.35% of GDP annually, and exempt any spending on defense that exceeds 1% of GDP. But this will not be as easy to achieve. Relaxing Germany’s debt brake will require two thirds of votes in the German parliament meaning Merz’s coalition will need to rely on Greens to support his plan too. For the moment, the Greens have threatened to vote against the package as they think the plan does not invest enough on environmental actions and climate protection. While this is not a done deal, there is consensus on the need to increase spending in the years to come.
- EU responds to Trump’s 25% tariff hikes: On March 12th, the European Commission announced its response to Trump’s steel and aluminum tariffs, adopting a two-step approach to the issue. First, the Commission has decided to reinstate the existing countermeasures of 2018 and 2020 against the US, targeting 8 billion euros worth of US imports coming to Europe. Second, the Commission has also put forward a package of new countermeasures worth 18 billion euros on US exports as a response to US tariffs on EU products. The first measure is expected to take immediate effect on April 1st, and the second one by mid-April. Tariffs and the EU’s counter-tariffs are expected to affect certain sectors in the EU, but the macroeconomic impact will be contained.
As risks loom, growth in the Euro Area will remain lackluster in the short run.
Business activity to grow marginally in H1 2025. Activity in the private sector in the Euro Area (EA) continued to expand marginally according to February’s Purchasing Managers’ Index (PMI) data. Factory output in the region improved to 47.6, increasing for the third month in a row and reaching its highest point in two years. Separate data from the European Commission showed the rise in sentiment was driven mainly by improvements in production expectations and export orders. Contrary to manufacturing, activity growth in services decelerated in February, falling from 51.3 to 50.6. The drop was largely due to services sentiment in France which took a strong hit following the announcement of major tax hikes (and spending cuts) for 2025. On the demand side, consumer confidence increased further suggesting private spending will remain supportive to economic activity in Q1. The export outlook has also turned less favorable in anticipation of the European Commission’s imposing retaliatory tariffs on US imports worth nearly 26 billion euros. Summing up, following weak growth of 0.1% in Q4 2024, the EA economy is projected to expand at around 0.2% in Q1 and H1 2025, before increasing by 0.3% in the second half of the year. In annual terms, we still see the region growing by 0.9% in 2025, but we downgrade slightly our forecasts for 2026, now expecting output to grow by 1.2%.
Headline inflation declines for the first time in five months. Annual inflation in the EA declined to 2.4% in February, down from 2.5% in January. The decline was solely driven by a significant fall in annual energy prices, while food inflation increased from 2.3% to 2.7% year-on-year. Core inflation, also decreased to 2.6% reaching its lowest value in three years. Yearly goods inflation increased marginally from 0.5% to 0.6%, while services inflation decreased from 4.0% to 3.8% year-on-year. Looking ahead, headline inflation is well on track to continue falling in 2025 as domestic demand, despite signs of gaining momentum, will remain subdued by normal (pre-COVID) standards.
The ECB cut rates to 2.5% but the pace of easing becomes more uncertain. On March 6th, the European Central Bank (ECB) lowered its key rates by another 25 basis points (bp), bringing its main policy rate (i.e., deposit) at 2.5%. Looking ahead, the monetary path the bank is going to follow has become less clear. In her recent speech in Frankfurt, Christine Lagarde, the ECB’s president highlighted that pre-committing to a monetary path in an environment of multiple, highly uncertain and persistent “two-sided” shocks could hurt “the bank’s agility to react appropriately”. We continue to believe that the ECB will resume its easing cycle because the reasons that explain it are still there, namely declining corporate profits and wages, renewed prospects of trade fragmentation and an economy suffering from cyclical challenges and persisting structural weaknesses. As a result, we make no changes to our monetary projections expecting the bank to lower rates anywhere from two to three more times in 2025, bringing its main policy rate to as low as 1.75% by the end of the year. However, as we will discuss further down, there are also important upside risks that might lead us to change our growth forecast as well as the ECB’s policy path.
Unemployment remains at an all-time low, but employment expectations turn more pessimistic. The European labor market remains resilient. Recent data show that the unemployment rate continues at the all-time low levels of 6.3%. Employment expectations, however, declined in February with the indicator falling from 98.5 in January to 97.0, suggesting EA business leaders intend to scale back on their hiring plans in the region. Nonetheless, the Euro Area labor market should remain robust in the year ahead. We still see unemployment rate stabilizing at around 6.5% in 2025 and employment rising, though more slowly than in 2023 and 2024.
There are two upside risks that can be economically significant, and one downside risk that is, by comparison, less impactful.
- The EU rearms. European Commission president von der Leyen announced the possible mobilization of €800 billion to boost defense spending over a period of four years. The intention is to have €650 billion in member states increased defense spending, and the rest €150 billion to be provided in the form of European loans to countries. This will provide, when implemented, a considerable fiscal stimulus across all member states and increase significantly aggregate demand that will in turn increase growth in the short run.
- Germany’s defense spending plan: Germany’s chancellor-to-be, Friedrich Merz, with its likely coalition partner, SPD, announced earlier in March a plan to pump hundreds of billions of euros (between €500 and €800 billion) to be dedicated to both defense and infrastructure. In order to do that, they proposed to reform the country’s debt brake, which limits spending to 0.35% of GDP annually, and exempt any spending on defense that exceeds 1% of GDP. But this will not be as easy to achieve. Relaxing Germany’s debt brake will require two thirds of votes in the German parliament meaning Merz’s coalition will need to rely on Greens to support his plan too. For the moment, the Greens have threatened to vote against the package as they think the plan does not invest enough on environmental actions and climate protection. While this is not a done deal, there is consensus on the need to increase spending in the years to come.
- EU responds to Trump’s 25% tariff hikes: On March 12th, the European Commission announced its response to Trump’s steel and aluminum tariffs, adopting a two-step approach to the issue. First, the Commission has decided to reinstate the existing countermeasures of 2018 and 2020 against the US, targeting 8 billion euros worth of US imports coming to Europe. Second, the Commission has also put forward a package of new countermeasures worth 18 billion euros on US exports as a response to US tariffs on EU products. The first measure is expected to take immediate effect on April 1st, and the second one by mid-April. Tariffs and the EU’s counter-tariffs are expected to affect certain sectors in the EU, but the macroeconomic impact will be contained.
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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