Eurozone - Frontloading at the front of the year

Despite significant uncertainty surrounding new trade policy from the US administration and notable events like Germany's successful debt-brake reform, the macroeconomic data has largely aligned with expectations. Growth remains subdued following the 0.1% q/q expansion in 24Q4, but as showcased by the March PMIs, the eurozone economy remains solidly on a recovery path at the end of Q1. Supporting near term activity is frontloading by US companies to circumvent current and possible future tariffs, which is supporting eurozone exports. The March PMIs showed the first signs of this. Frontloading has likely helped boost the eurozone manufacturing PMI output subcomponent, lifting it into expansionary territory for the first time since early 2023. Although this signal alone is insufficient to suggest the beginning of recovery for the eurozone manufacturing sector, it does offer some short-term relief, albeit temporary. This coincides with expectations of higher demand for eurozone industrial goods in the medium term, due to increased defence spending and German fiscal largesse, which is also expected to boost demand for industrial goods, especially in Germany. Zooming out, we expect eurozone growth to pick up in the first half of 2025, driven by stronger consumer spending and the aforementioned frontloading of exports to the US ahead of likely tariffs, with growth expected to slow in the second half of 2025 as the tariff shock hits.

In February, flash HICP inflation showed a slight decline, with headline inflation easing to 2.4% year-on-year from January's 2.5%. Core inflation also dipped to 2.6% from 2.7%. Contributing to the fall in core inflation and important for the ECB, services inflation fell to 3.7% year-on-year from 3.9%, marking its lowest level since the energy crisis, excluding last April's Easter distortion. The ECB's seasonally adjusted data revealed a smaller month-on-month increase of 0.3% compared to previous February figures of 0.5%, indicating a promising shift in inflation dynamics as businesses absorb wage increases in their margins instead of transferring costs to consumers. Looking forward, services inflation is expected to gradually decline but remain above pre-pandemic levels throughout the year. This decline is expected to drive headline inflation down to the ECB's 2% target by mid-2025. Thereafter, we expect the growth hit from US trade tariffs to push inflation below target towards the end of the year.

At the beginning of March, the ECB cut its key policy rates by another 25bp, as was widely expected, taking the key deposit rate to 2.5%. Our base case sees the ECB pausing rate cuts at the April meeting, though with markets pricing in a 70% probability of a cut, this is going to be a close call. Supporting a pause: 1) the Governing Council has indicated rates are getting closer to neutral; 2) in contrast to us, the ECB sees the tariff shock adding 0.5pp to inflation and with a relatively small growth impact of -0.3pp; 3) prospects for higher fiscal spending also supports the growth and inflation outlook. We think June will be the optimal time to resume cuts, when ECB staff updates its projections. Still, given that rates are still restrictive, and given where market pricing is, the Governing Council may yet opt continue cutting for now and to pause at a later date.