Eurozone - Keep calm and carry on

Europe is currently in the throes of massive geopolitical tectonic shifts, and it will take time to discern the precise macro-economic constellation that will result. We have given our initial takes on the impact of US tariffs and higher defence spending, and will build on this analysis as the details begin to crystalise. But broadly speaking and from a purely macro-economic standpoint, we continue to think the tariff shock is going to be the overwhelming factor impacting growth over the coming year. In the meantime, the economic backdrop is evolving in line with our base case. Growth remains subdued, notwithstanding the slight upward revision to Q4 GDP growth (to 0.1% q/q from 0% in the flash estimate). However, as signalled by the February PMIs, the economy remains on a recovery path, with the composite PMI holding steady just above the expansion threshold at 50.2. The stability in the aggregate eurozone PMI masks a significant reversal in fortunes of France and Germany, with Germany recovering and France surprising sharply to the downside. At the same time, the periphery continues to outperform both of the eurozone’s big hitters. Overall, we expect growth to pick up in the first half of 2025, driven by stronger consumer spending and possible 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.

Inflation meanwhile surprised slightly to the upside in February but was broadly steady at 2.5%. As expected and similar to January, the details showed a temporary lift from energy – both from base effects but also the recent rise in gas and electricity prices (which are already rapidly retracing in wholesale markets). More promisingly, services inflation came in a touch cooler than expected – albeit still elevated – while the Indeed wage growth tracker moved another leg down to a new post-energy crisis low of 2.6% y/y. The more lagging negotiated wages measure also slowed sharply in Q4, to 4.1% from 5.4% in Q3, and the ECB’s forward-looking tracker suggests a further significant slowdown over the coming year. While elevated wage growth is likely to keep services inflation on the high side for some time yet, we do expect it to cool gradually as the year progresses. As the ECB has noted, there are increasing signs that businesses are to some extent absorbing higher wage costs in their margins rather than passing them on to consumers as readily as previously. This perhaps reflects the cooling in services demand, as trends such as the post-pandemic ‘revenge travel’ fades and consumers switch back to goods. We continue to expect inflation to be sustainably back at the ECB’s 2% by the middle of this year, and to fall below target as we move into 2026.

As for the ECB, recent weeks were notable for the shift in tone from Governing Council hawks such as Isabelle Schnabel and Pierre Wunsch. Schnabel called for a debate to ‘pause or halt’ rate cuts, while Wunsch warned against ‘sleepwalking’ into too many rate cuts. These comments come as no surprise to us, because we expected division on the Governing Council to start increasing again as rates approached the upper bound of neutral estimates. While we expect the ECB to cut again when it meets next week, taking the deposit rate to 2.5%, we have pencilled in a pause at the April meeting. But this pause is unlikely to last: the timing will depend on when exactly new US tariffs land, but when they do, we expect the ECB to keep cutting until the deposit rate reaches 1%, likely by early 2026. See also our ECB preview.