Strong growth in Q1 unlikely to continue in Q2. Economic growth in the Euro Area (EA) has shown signs of deceleration in the three months to June. Survey data, as captured by S&P’s PMI indicator, suggest that business activity in Q2 was below Q1 levels. Despite modest improvements in June, services growth remains sluggish overall and still below the levels seen in 2024 or early 2025. Sentiment continued to improve in June in manufacturing, with the respective PMI reaching its highest level in three years; however, hard data and alternative surveys paint a less optimistic picture. Following strong gains in March owing to frontloading of exports to the US, industrial production declined steeply in April in Germany and France. Meanwhile, the EC’s survey of manufacturers indicates expectations of rising stocks of finished products and falling exports. Consumer confidence edged down from -15.2 in May to -15.3 in June, with overall sentiment levels in Q2 falling below those in Q1. As a result, we now expect private spending to have entered Q2 on a somewhat weaker footing, putting additional pressure on the region’s growth prospects. Looking beyond Q2, downside risks to growth continue to loom. Unresolved EU-US trade disputes remain the undisputed top concern around the region’s outlook. While the broader consensus is for the EU to strike a UK-style trade agreement, failure to do so would activate tariffs on August 1, with immediate negative repercussions across the economy. This risk comes on top of a growing list of domestic challenges the EA economy is already facing. However, one notable upside risk is countries’ defense commitments that can generate fiscal expansion in the short run. Germany’s recent 2025 budget announcement and its strong commitment to accelerate defense spending starting already this year will certainly add to the EA’s growth prospects. Yet, we still expect benefits to become more pronounced in 2026 and beyond. All in all, and assuming a full-blown trade war between Europe and the US is avoided, we forecast EA GDP growth to average 0.9% in 2025 and accelerate to 1.3% in 2026. This rebound is mostly supported by easing trade uncertainty, and better growth prospects thanks to Germany’s fiscal stimulus.
Inflation reaches 2% in June, dodging the worst-case scenario. Annual headline inflation in the EA reached the ECB’s medium-term target, edging up 0.1 percentage points (pp) from a month ago. Despite initial fears that the Iran-Israel’s “12-Day War” would lead to energy inflation overshooting, annual energy prices declined by 2.8% in June. Core inflation, which excludes the more volatile components of food and energy, held steady at 2.3%. Goods price growth slowed by a tenth of a percentage point, to 0.5%, while services inflation remained unchanged at 3.2%. The short-term inflation outlook has changed very little since a month ago. We still see two-sided risks lingering. On the upside, geopolitical tensions, ongoing trade frictions, volatile energy prices and increased government spending (e.g., on defense) could put upward pressures on inflation. On the downside, weak domestic demand, a strong euro appreciation now 14% higher against the US dollar than in January, and China’s export dynamics and prospects of redirecting any excess capacity to Europe could exert downward pressure on price growth. In the near-term, we see downside risks to the inflation outlook prevailing. Thus, we leave our inflation forecasts unchanged – still expecting headline inflation to fall to 1.9% in 2026, down from 2.1% in 2025, with core inflation declining to 2.0%, from 2.4% in 2025.
The ECB is expected to pause rate cuts in July, but further easing remains likely if growth prospects do not meet expectations. In the June 5 press conference, the ECB’s president Christine Lagarde, underlined that the ECB is getting to an end of its monetary policy cycle, leaving the door wide open for a pause in July. A stronger-than-expected economic recovery in Q1 and inflation finally aligning exactly with the ECB’s medium-term objective of 2%, reinforces this expectation. Looking beyond July, incoming summer data will be critical in shaping the ECB’s decision in September. For now, with inflation concerns receding but growth prospects showing signs of deterioration, we expect the ECB will find room to deliver one additional rate cut in 2025, most likely in September, as part of its broader effort to stimulate the economy. Accordingly, we are revising our terminal rate forecast downward to 1.75%, from 2.00% previously.
Unemployment increases to 6.3% in May. In May, the unemployment rate in the EA remained near historic lows, ticking up slightly from 6.2% in April to 6.3%. Italy stands out, as the number of unemployed persons increased sharply in May to 6.5%, from 6.1% a month ago (112,000 people). According to ISTAT, the steep increase in the number of unemployed persons was due to a significant increase in the number of inactive people entering the Italian labor force. In Germany, the unemployment rate remained unchanged at 3.7%, while the French and Spanish labor markets showed additional signs of improvement. Overall, and excluding this month’s volatile Italian data, the outlook for the EA’s labor market has not changed from a month ago, and we are still expecting it to remain robust in 2025 and 2026.
Two issues present upside risks for the EA’s outlook. However, political uncertainty in a few countries raises downside risks.
- Germany’s 2025 budget announcement. On June 24, the Federal Cabinet approved a draft budget for 2025 and a framework budget through 2026 along with further details of its medium-term fiscal plan, up until 2029. The budget, expected to be adopted in September, marks a clear shift in Germany’s fiscal stance, signaling the government’s commitment to modernize its economy by increasing spending in key areas such as digitalization, innovation, defense, R&D, and climate transition. The government plans to invest a record amount of 115bn euros this year and 124bn euros in 2026. Defense spending is also projected to rise significantly by 2029, to reach the newly agreed NATO target of 3.5% of GDP. Given the scale and focus of this policy, we now expect its impact to begin materializing as early as 2026. As a result, we raise our GDP growth forecasts for the German economy, from 1.2% a month ago to now 1.4%. However, to finance this strategy, the government will need to raise an estimated 850bn euros in additional debt. This will have a substantial impact on its public debt trajectory, which stood at 63% of GDP in 2024.
- Allies agree to increase defense spending. Nato members agreed on June 25 at the summit in the Hague to increase defense and security-related spending from 2% to 5% of GDP by 2035. The 5% target builds upon the existing 2% guideline, which had been established in 2014. Of this 5%, members agreed to allocate at least 3.5% of GDP on “pure” defense (e.g., drones, weapons, etc.) and the remainder 1.5% will be for protecting critical infrastructure, defense networks and for overall strengthening their defense industrial base. Allies also agreed to submit annual plans to show a credible and incremental path to reach the 5% objective, while the trajectory and balance of spending will be reviewed in 2029. With the exception of Germany, other countries have not outlined yet concrete plans on how they expect to reach this 5% by 2029, or how they will finance these extra expenditures. It is therefore not easy to quantify the impact of a project of this scale on each economy. However, while injecting billions of euros into the economy should support stronger medium-term growth, it also raises growing concerns about rising public debt.
- Political uncertainty in France and Spain could weigh on their economic outlook in coming months. Political uncertainty looming again in some of Europe’s largest economies. In France, Bayrou’s government survived on July 1 a no confidence vote – the eighth of his government –, tabled by the Socialist Party (PS) following the collapse of talks on lowering the retirement age from 64 to 62. Bayrou has no majority in the National Assembly, with the vote underscoring his party’s fragility. The risk of another political crisis – or even a government collapse – could send French bond spreads higher and, thus, increasing the financing costs for companies and households. In Spain, corruption allegations and mounting scandals have increased pressure on Prime Minister Pedro Sanchez to call for a snap election and threaten to throw the Spanish economy into political gridlock, eventually also denting the growth outlook of EA’s strongest economic performer.
Strong growth in Q1 unlikely to continue in Q2. Economic growth in the Euro Area (EA) has shown signs of deceleration in the three months to June. Survey data, as captured by S&P’s PMI indicator, suggest that business activity in Q2 was below Q1 levels. Despite modest improvements in June, services growth remains sluggish overall and still below the levels seen in 2024 or early 2025. Sentiment continued to improve in June in manufacturing, with the respective PMI reaching its highest level in three years; however, hard data and alternative surveys paint a less optimistic picture. Following strong gains in March owing to frontloading of exports to the US, industrial production declined steeply in April in Germany and France. Meanwhile, the EC’s survey of manufacturers indicates expectations of rising stocks of finished products and falling exports. Consumer confidence edged down from -15.2 in May to -15.3 in June, with overall sentiment levels in Q2 falling below those in Q1. As a result, we now expect private spending to have entered Q2 on a somewhat weaker footing, putting additional pressure on the region’s growth prospects. Looking beyond Q2, downside risks to growth continue to loom. Unresolved EU-US trade disputes remain the undisputed top concern around the region’s outlook. While the broader consensus is for the EU to strike a UK-style trade agreement, failure to do so would activate tariffs on August 1, with immediate negative repercussions across the economy. This risk comes on top of a growing list of domestic challenges the EA economy is already facing. However, one notable upside risk is countries’ defense commitments that can generate fiscal expansion in the short run. Germany’s recent 2025 budget announcement and its strong commitment to accelerate defense spending starting already this year will certainly add to the EA’s growth prospects. Yet, we still expect benefits to become more pronounced in 2026 and beyond. All in all, and assuming a full-blown trade war between Europe and the US is avoided, we forecast EA GDP growth to average 0.9% in 2025 and accelerate to 1.3% in 2026. This rebound is mostly supported by easing trade uncertainty, and better growth prospects thanks to Germany’s fiscal stimulus.
Inflation reaches 2% in June, dodging the worst-case scenario. Annual headline inflation in the EA reached the ECB’s medium-term target, edging up 0.1 percentage points (pp) from a month ago. Despite initial fears that the Iran-Israel’s “12-Day War” would lead to energy inflation overshooting, annual energy prices declined by 2.8% in June. Core inflation, which excludes the more volatile components of food and energy, held steady at 2.3%. Goods price growth slowed by a tenth of a percentage point, to 0.5%, while services inflation remained unchanged at 3.2%. The short-term inflation outlook has changed very little since a month ago. We still see two-sided risks lingering. On the upside, geopolitical tensions, ongoing trade frictions, volatile energy prices and increased government spending (e.g., on defense) could put upward pressures on inflation. On the downside, weak domestic demand, a strong euro appreciation now 14% higher against the US dollar than in January, and China’s export dynamics and prospects of redirecting any excess capacity to Europe could exert downward pressure on price growth. In the near-term, we see downside risks to the inflation outlook prevailing. Thus, we leave our inflation forecasts unchanged – still expecting headline inflation to fall to 1.9% in 2026, down from 2.1% in 2025, with core inflation declining to 2.0%, from 2.4% in 2025.
The ECB is expected to pause rate cuts in July, but further easing remains likely if growth prospects do not meet expectations. In the June 5 press conference, the ECB’s president Christine Lagarde, underlined that the ECB is getting to an end of its monetary policy cycle, leaving the door wide open for a pause in July. A stronger-than-expected economic recovery in Q1 and inflation finally aligning exactly with the ECB’s medium-term objective of 2%, reinforces this expectation. Looking beyond July, incoming summer data will be critical in shaping the ECB’s decision in September. For now, with inflation concerns receding but growth prospects showing signs of deterioration, we expect the ECB will find room to deliver one additional rate cut in 2025, most likely in September, as part of its broader effort to stimulate the economy. Accordingly, we are revising our terminal rate forecast downward to 1.75%, from 2.00% previously.
Unemployment increases to 6.3% in May. In May, the unemployment rate in the EA remained near historic lows, ticking up slightly from 6.2% in April to 6.3%. Italy stands out, as the number of unemployed persons increased sharply in May to 6.5%, from 6.1% a month ago (112,000 people). According to ISTAT, the steep increase in the number of unemployed persons was due to a significant increase in the number of inactive people entering the Italian labor force. In Germany, the unemployment rate remained unchanged at 3.7%, while the French and Spanish labor markets showed additional signs of improvement. Overall, and excluding this month’s volatile Italian data, the outlook for the EA’s labor market has not changed from a month ago, and we are still expecting it to remain robust in 2025 and 2026.
Two issues present upside risks for the EA’s outlook. However, political uncertainty in a few countries raises downside risks.
- Germany’s 2025 budget announcement. On June 24, the Federal Cabinet approved a draft budget for 2025 and a framework budget through 2026 along with further details of its medium-term fiscal plan, up until 2029. The budget, expected to be adopted in September, marks a clear shift in Germany’s fiscal stance, signaling the government’s commitment to modernize its economy by increasing spending in key areas such as digitalization, innovation, defense, R&D, and climate transition. The government plans to invest a record amount of 115bn euros this year and 124bn euros in 2026. Defense spending is also projected to rise significantly by 2029, to reach the newly agreed NATO target of 3.5% of GDP. Given the scale and focus of this policy, we now expect its impact to begin materializing as early as 2026. As a result, we raise our GDP growth forecasts for the German economy, from 1.2% a month ago to now 1.4%. However, to finance this strategy, the government will need to raise an estimated 850bn euros in additional debt. This will have a substantial impact on its public debt trajectory, which stood at 63% of GDP in 2024.
- Allies agree to increase defense spending. Nato members agreed on June 25 at the summit in the Hague to increase defense and security-related spending from 2% to 5% of GDP by 2035. The 5% target builds upon the existing 2% guideline, which had been established in 2014. Of this 5%, members agreed to allocate at least 3.5% of GDP on “pure” defense (e.g., drones, weapons, etc.) and the remainder 1.5% will be for protecting critical infrastructure, defense networks and for overall strengthening their defense industrial base. Allies also agreed to submit annual plans to show a credible and incremental path to reach the 5% objective, while the trajectory and balance of spending will be reviewed in 2029. With the exception of Germany, other countries have not outlined yet concrete plans on how they expect to reach this 5% by 2029, or how they will finance these extra expenditures. It is therefore not easy to quantify the impact of a project of this scale on each economy. However, while injecting billions of euros into the economy should support stronger medium-term growth, it also raises growing concerns about rising public debt.
- Political uncertainty in France and Spain could weigh on their economic outlook in coming months. Political uncertainty looming again in some of Europe’s largest economies. In France, Bayrou’s government survived on July 1 a no confidence vote – the eighth of his government –, tabled by the Socialist Party (PS) following the collapse of talks on lowering the retirement age from 64 to 62. Bayrou has no majority in the National Assembly, with the vote underscoring his party’s fragility. The risk of another political crisis – or even a government collapse – could send French bond spreads higher and, thus, increasing the financing costs for companies and households. In Spain, corruption allegations and mounting scandals have increased pressure on Prime Minister Pedro Sanchez to call for a snap election and threaten to throw the Spanish economy into political gridlock, eventually also denting the growth outlook of EA’s strongest economic performer.
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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