Europe’s economic outlook: a turning point?

As the European Central Bank (ECB) signals a slowdown in monetary easing, the Eurozone faces a complex mix of deflationary pressures, geopolitical uncertainty, and structural challenges - particularly in Germany. This insight explores:

• ECB at a crossroads: inflation cools and rate cuts slow as focus shifts to growth.
• Germany’s fiscal pivot: major investments in defence and infrastructure aim to revive the economy.
• Trade and growth uncertainty: external negotiations and internal reforms shape the region’s next steps.

On June 5, the ECB decided to cut its deposit rates by 25 basis points to 2%. The narrative adopted after the policy meeting indicates that the monetary policy easing cycle is nearing its end. Inflation in May 2025 landed at 1.9% year-on-year, amid deflationary pressure driven by several factors, namely, import levels remaining consistent despite the global trade war, while exports decreased substantially as shown in Exhibit 1. Indeed, the EU stance on trade as of today is against applying significant taxes on imports, which in turn allows foreign products to penetrate the European market and maintaining the pressure on prices.  

Despite the decrease in exports and the recent ECB rate cuts, the euro strengthened against the greenback. A stronger euro and lower energy prices limit the risk of imported inflation. The ECB’s forecasts indicate a potential depreciation in the cost of crude oil next year. It currently trades at around USD 65 per barrel as shown in Exhibit 2. The limited impact of the recent geopolitical turmoil on the crude oil price supports the narrative of lower prices driven by fundamentals.

Inflation forecasts for 2025 and 2026 have been revised downward by the ECB by -0.3%, amid a stronger euro and lower energy prices. For 2025, the ECB inflation forecasts indicate a 2% average while for 2026, forecasts reach 1.6%, before rising again to 2% in 2027. In contrast to inflation forecasts, economic growth projections remain unchanged, with the ECB expecting real GDP in the Eurozone to grow by 0.9% in 2025, 1.1% in 2026 and 1.3% in 2027. The optimistic tone adopted by the ECB on the monetary stimulus after the policy meeting is contingent upon the outcome of the trade talks with the US. Considering the latest inflation and GDP growth forecasts released by the ECB, the decision around rate cuts should be more influenced by economic growth concerns than inflation concerns in the coming months.

Another driving factor that will impact the monetary decisions and economic forecasts made by the ECB is the state of the German economy. Germany announced a dramatic shift in its fiscal policy, recently declaring its aim to reach 3.5% of GDP spending on defence by 2029, and unlocked funds to modernise its infrastructure. Despite the announcements, the ECB did not amend its growth forecasts for both Germany and the Eurozone as shown in Exhibit 3.

The German GDP shrank 0.3% quarter-to-quarter during Q2 of 2025, as exports to the US took a hit. The German economy posted two consecutive years of recession in 2023 and 2024. The recession was caused by structural factors as well as a challenging geopolitical environment. Key drivers of this recession include shrinking exports to China as Chinese GDP slows down, the energy shock caused by Russia’s invasion of Ukraine, an ageing population and ageing infrastructure, heavy regulatory constraints and high corporate taxes. Despite a record-high trade surplus sustained over several year, the German central and local governments emphasised fiscal discipline at the expense of economic growth. Public investment has remained stable at about 2 to 3% of GDP in recent years, which is low compared to other countries in the region, as it usually ranges between 3 to 5%. Fiscal discipline allowed the debt to GDP ratio to shrink by about 16% in 15 years. The fiscal discipline was institutionalised as a debt brake was included in the constitution to prevent rising debt levels.