Stagnant eurozone economy faces more headwinds

The new year has brought new ambitions in Europe. The European Commission has launched its “Competitiveness Compass,” a plan to implement some of Draghi's recommendations. Among the action points are cutting red tape, lowering barriers to the single market, and making the European capital market more efficient. These measures are certainly needed given the headwinds the eurozone economy is currently facing.

It now seems almost certain that US President Donald Trump is planning to levy increased import tariffs on European goods. Whether he will wait until his administration has finished a comprehensive report on US trade policy (deadline 1 April) remains to be seen, but chances are high that the US will impose tariffs on the EU in the second quarter. The EU will likely react with specific retaliations while trying to appease Trump with promises of more LNG and weapons purchases. One thing is certain: more uncertainty. This might weigh on business investment. We anticipate that some exports will be shifted to the first quarter, with some weakening likely hereafter. Even if we are not yet on course for a full-blown trade war, the skirmishes are already stagflationary in nature; growth will be negatively affected, while retaliatory tariffs in Europe are inflationary.

The eurozone ended the year on a weak note, with GDP stagnating in the fourth quarter and even contracting in France and Germany. Both the PMI and the European Commission’s sentiment indicator slightly increased in January, though they remain at depressed levels. While this seems to point to a bottoming out of the economic cycle, the weak orders component in the survey does not indicate a significant acceleration in the short run. We have slightly tweaked our quarterly growth profile, but our growth forecast for this year remains unchanged at 0.7%. Due to a weaker carry-over effect, we had to lower our 2026 GDP growth forecast to 1.2%.

The flash estimate of January's harmonised index of consumer price (HICP) inflation came in at 2.5%, the fourth increase in a row. Core inflation remained at 2.7%, with services prices rising 3.9% year-on-year. Most wage trackers are now starting to show a deceleration in wage growth, and the European Central Bank relies on this trend and on tighter profit margins for inflation to return to target. We agree that the inflation trend is still downward, but the further decline in inflation is unlikely to be smooth. Energy and food prices are expected to add to inflation in the coming months. Potential import tariffs are also inflationary. In the European Commission’s Business Survey, selling price expectations increased in all major sectors (manufacturing, services, retail, and construction) in January and are now all above their historical averages. Taking this into account, we increased our inflation forecast to 2.4% for 2025 but kept it at 2.2% for 2026.

The ECB cut interest rates again by 25 basis points in January, bringing the deposit rate to 2.75%. While inflation was still above target, the ECB justified this by stating that monetary policy is still restrictive. However, the closer it comes to the mythical “neutral rate,” deemed to be around 2%, the more cautious the ECB is likely to become. In the wake of weak growth, we do not exclude the possibility of the ECB adopting a slightly expansionary monetary policy, but this will be the end stage of a very gradual process. We therefore expect a 25bp rate cut at every policy meeting to reach 1.75% by summer. Barring a major crisis, the ECB is unlikely to cut any further than this.