Economic activity in the Euro Area is expected to pick up in Q3. The S&P Global Purchasing Managers’ Index (PMI) rose in August to 51.1—its highest level in more than a year—signaling renewed momentum in the economy. At the sectoral level, the recovery in factory activity remains the main driver of improved business sentiment. The manufacturing PMI climbed to 50.6, making the first expansion in industrial output since June 2022. Services also continued to grow, though at a slightly slower pace than in July, with the index at 50.7. We believe that more details around the implementation of US tariffs, along with somewhat more optimistic expectations around exports and services demand, have been key factors behind August’s stronger PMI reading. However, we also take note that country-level data reveals a more nuanced story—one of a region that keeps growing at three distinct speeds. Spain continues to outperform, with its composite PMI holding firm at around 54. Meanwhile, Germany and Italy also remain in expansion territory, though growing at a significantly more moderate pace, close to 51. France, by contrast, is the only large economy still lagging, with private sector activity contracting for the 12th consecutive month. Political uncertainty around the 2026 budget, combined with persistent underinvestment and weak productivity growth, represent hurdles that will be difficult to overcome. To reflect these increasing challenges, we downgrade slightly our GDP forecast for France, now expecting the country to grow in 2025 and 2026 by 0.6% and 0.7%, respectively. As for the Euro Area as a whole, growth forecasts remain unchanged at 0.9% and 1.2% for 2025 and 2026 respectively, overall reflecting an economy that remains resilient but where the pace of recovery is likely to stay subdued.
Inflation edges higher but remains near the ECB’s 2% target. Annual headline inflation in the EA ticked up to 2.1% in August, a modest 0.1 percentage points (pp) increase from June and July, driven by a slower decline in energy prices. Food inflation eased to 3.2% year-on-year, while core inflation (which excludes the more volatile components of energy, and food, alcohol and tobacco) held steady at 2.3%. The latest readings suggest little change in the short-term outlook for inflation. Energy year-on-year prices growth are expected to remain negative until the end of 2026 due to base effects. Services inflation should gradually ease as wage growth moderates, while goods annual inflation should revert to its long-run average of 0.3% to 0.5% by the end of next year. We still project food inflation to remain elevated and reducing at a slower pace than other key items of the inflation basket. Against this backdrop, we see headline inflation declining from 2.1% in 2025 to 1.7% in 2026, with core inflation easing from 2.5% to 1.9% over the same period.
ECB to pause again in September. Following its July pause, the ECB is widely expected to hold rates steady again at the September 11 meeting—and there are solid reasons for this. Inflation is now close to the 2% target, the economy has resumed expansion and is proving more resilient than anticipated, near-term growth prospects are somewhat improving, and the labor market remains robust. That said, we still leave open the possibility of one additional rate cut in 2025, should downside risks to growth materialize and activity weakens. For example, a further escalation in global trade tensions—particularly with the US—could dampen exports and weigh negatively on investments and consumption, providing the main rationale for such a move. Conversely, higher defense and infrastructure spending could also put upward pressure to prices. Assuming such risks do not materialize and given signs of resilience in the economy, we are revising our terminal rate forecast up to 2.00% (from 1.75%) for 2025 and remain in a ‘wait-and-see’ mode, to evaluate what we learn from Q3 GDP data.
A resilient labor market will keep household spending afloat. Following upward revisions in June and July, the EA unemployment rate fell back in July to its all-time low of 6.2%, underscoring the labor market’s role as the region’s main source of economic strength and resilience. We expect this to continue in the months ahead, particularly as employment expectations improve further, unemployment fears among consumers subside and the economic momentum is building up. Most importantly, a robust labor market will continue to play a crucial role in sustaining much-needed private consumption in the months ahead.
We outline three risks to the region:
- EU-US trade talks remain open and under pressure. Despite a joint statement issued on August 21 that confirms a uniform 15% tariff on most EU exports, major uncertainties persist in the EU-US trade dialogue. The critical sticking point remains automotive exports: the U.S. has tied reducing the existing 27.5% tariffs on EU cars to 15%, only after the EU removes tariffs on U.S. industrial goods. Compounding this uncertainty, President Trump has escalated pressure by threatening new tariffs and export restrictions against the EU in response to its sweeping Digital Services Act (DSA) and Digital Markets Act (DMA). The EU has firmly defended its digital rules, asserting they are sovereign regulatory tools designed to safeguard public welfare, not target American tech firms—and that they’re separate from trade agreements. Looking forward, if the EU moves forward implementing its digital legislation, renewed trade tensions with the US becomes increasingly likely—an outcome that could significantly impact the region’s growth outlook.
- France is entering a new phase of political turmoil. Prime Minister (PM) Francois Bayrou, who has put forward a controversial €44bn austerity budget—including measures such as scrapping two public holidays—faces an almost certain defeat in a September 8 confidence vote. If ousted, president Macron will be left with few good options. He could call snap elections, or he could propose appointing a new PM. But for the moment none of these options offers a clear solution: fresh elections would likely return another fragmented government, while a new PM would still struggle to secure support for such a restrictive budget. Moreover, the political crisis is further compounded by rising social tensions as calls for protests and strikes threaten to add even greater strain to already fragile public finances. Markets have reacted swiftly to France’s political reality: the spread between French and German 10-year bonds has widened to levels not seen since the 2012-2013 sovereign debt crisis. Already on weak footing, latest political developments in France make economic recovery a lot more difficult.
- Germany: potential welfare reforms pose risks to the country’s recovery. At a recent state-level party conference, Chancellor Friedrich Merz warned that Germany’s current social welfare state is no longer affordable given the country’s current economic output. He highlighted the need to reform the social insurance system in order to contain rising costs and close gaps in the federal budget. Yet, reduce spending for the purposes of sustaining social welfare—especially as billions are directed toward defense and infrastructure projects—risks undermining private consumption and eroding consumer confidence. This, in turn, could weaken domestic demand and slow the broader economic recovery that Germany urgently needs.
Economic activity in the Euro Area is expected to pick up in Q3. The S&P Global Purchasing Managers’ Index (PMI) rose in August to 51.1—its highest level in more than a year—signaling renewed momentum in the economy. At the sectoral level, the recovery in factory activity remains the main driver of improved business sentiment. The manufacturing PMI climbed to 50.6, making the first expansion in industrial output since June 2022. Services also continued to grow, though at a slightly slower pace than in July, with the index at 50.7. We believe that more details around the implementation of US tariffs, along with somewhat more optimistic expectations around exports and services demand, have been key factors behind August’s stronger PMI reading. However, we also take note that country-level data reveals a more nuanced story—one of a region that keeps growing at three distinct speeds. Spain continues to outperform, with its composite PMI holding firm at around 54. Meanwhile, Germany and Italy also remain in expansion territory, though growing at a significantly more moderate pace, close to 51. France, by contrast, is the only large economy still lagging, with private sector activity contracting for the 12th consecutive month. Political uncertainty around the 2026 budget, combined with persistent underinvestment and weak productivity growth, represent hurdles that will be difficult to overcome. To reflect these increasing challenges, we downgrade slightly our GDP forecast for France, now expecting the country to grow in 2025 and 2026 by 0.6% and 0.7%, respectively. As for the Euro Area as a whole, growth forecasts remain unchanged at 0.9% and 1.2% for 2025 and 2026 respectively, overall reflecting an economy that remains resilient but where the pace of recovery is likely to stay subdued.
Inflation edges higher but remains near the ECB’s 2% target. Annual headline inflation in the EA ticked up to 2.1% in August, a modest 0.1 percentage points (pp) increase from June and July, driven by a slower decline in energy prices. Food inflation eased to 3.2% year-on-year, while core inflation (which excludes the more volatile components of energy, and food, alcohol and tobacco) held steady at 2.3%. The latest readings suggest little change in the short-term outlook for inflation. Energy year-on-year prices growth are expected to remain negative until the end of 2026 due to base effects. Services inflation should gradually ease as wage growth moderates, while goods annual inflation should revert to its long-run average of 0.3% to 0.5% by the end of next year. We still project food inflation to remain elevated and reducing at a slower pace than other key items of the inflation basket. Against this backdrop, we see headline inflation declining from 2.1% in 2025 to 1.7% in 2026, with core inflation easing from 2.5% to 1.9% over the same period.
ECB to pause again in September. Following its July pause, the ECB is widely expected to hold rates steady again at the September 11 meeting—and there are solid reasons for this. Inflation is now close to the 2% target, the economy has resumed expansion and is proving more resilient than anticipated, near-term growth prospects are somewhat improving, and the labor market remains robust. That said, we still leave open the possibility of one additional rate cut in 2025, should downside risks to growth materialize and activity weakens. For example, a further escalation in global trade tensions—particularly with the US—could dampen exports and weigh negatively on investments and consumption, providing the main rationale for such a move. Conversely, higher defense and infrastructure spending could also put upward pressure to prices. Assuming such risks do not materialize and given signs of resilience in the economy, we are revising our terminal rate forecast up to 2.00% (from 1.75%) for 2025 and remain in a ‘wait-and-see’ mode, to evaluate what we learn from Q3 GDP data.
A resilient labor market will keep household spending afloat. Following upward revisions in June and July, the EA unemployment rate fell back in July to its all-time low of 6.2%, underscoring the labor market’s role as the region’s main source of economic strength and resilience. We expect this to continue in the months ahead, particularly as employment expectations improve further, unemployment fears among consumers subside and the economic momentum is building up. Most importantly, a robust labor market will continue to play a crucial role in sustaining much-needed private consumption in the months ahead.
We outline three risks to the region:
- EU-US trade talks remain open and under pressure. Despite a joint statement issued on August 21 that confirms a uniform 15% tariff on most EU exports, major uncertainties persist in the EU-US trade dialogue. The critical sticking point remains automotive exports: the U.S. has tied reducing the existing 27.5% tariffs on EU cars to 15%, only after the EU removes tariffs on U.S. industrial goods. Compounding this uncertainty, President Trump has escalated pressure by threatening new tariffs and export restrictions against the EU in response to its sweeping Digital Services Act (DSA) and Digital Markets Act (DMA). The EU has firmly defended its digital rules, asserting they are sovereign regulatory tools designed to safeguard public welfare, not target American tech firms—and that they’re separate from trade agreements. Looking forward, if the EU moves forward implementing its digital legislation, renewed trade tensions with the US becomes increasingly likely—an outcome that could significantly impact the region’s growth outlook.
- France is entering a new phase of political turmoil. Prime Minister (PM) Francois Bayrou, who has put forward a controversial €44bn austerity budget—including measures such as scrapping two public holidays—faces an almost certain defeat in a September 8 confidence vote. If ousted, president Macron will be left with few good options. He could call snap elections, or he could propose appointing a new PM. But for the moment none of these options offers a clear solution: fresh elections would likely return another fragmented government, while a new PM would still struggle to secure support for such a restrictive budget. Moreover, the political crisis is further compounded by rising social tensions as calls for protests and strikes threaten to add even greater strain to already fragile public finances. Markets have reacted swiftly to France’s political reality: the spread between French and German 10-year bonds has widened to levels not seen since the 2012-2013 sovereign debt crisis. Already on weak footing, latest political developments in France make economic recovery a lot more difficult.
- Germany: potential welfare reforms pose risks to the country’s recovery. At a recent state-level party conference, Chancellor Friedrich Merz warned that Germany’s current social welfare state is no longer affordable given the country’s current economic output. He highlighted the need to reform the social insurance system in order to contain rising costs and close gaps in the federal budget. Yet, reduce spending for the purposes of sustaining social welfare—especially as billions are directed toward defense and infrastructure projects—risks undermining private consumption and eroding consumer confidence. This, in turn, could weaken domestic demand and slow the broader economic recovery that Germany urgently needs.
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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