European Economic Outlook: Resilience in the face of shocks

Growth remained divergent across other European economies, although it generally exceeded the euro area average:

• Growth remained resilient in the Netherlands at 0.4% q/q and 1.5% y/y and accelerated sharply in Switzerland to 1.9% q/q and 2.3% y/y on the back of stronger external demand. By contrast, Belgium and Austria stagnated, remaining among Europe's weakest-performing economies.
• Poland and several other CEE economies (Slovenia, Lithuania, Bulgaria, Serbia) continued to grow strongly at around 3-4% y/y, supported by real income gains, expansionary fiscal policy and NextGenEU spending. Regional performance remained uneven, however, with solid growth of 1.5-2.0% y/y in Czechia, Croatia and Hungary, near-stagnation in Slovakia and a contraction in Romania amid fiscal tightening and high inflation.
• The Nordic economies recorded a strong quarter. Growth in Sweden accelerated to above 3% y/y. Denmark remained among Europe's fastest-growing economies, although headline growth continued to be disproportionately influenced by the pharmaceutical sector. Growth in Finland and Norway also accelerated to 1.6-2.0% y/y, although momentum in Norway’s mainland economy remained sluggish as elevated interest rates constrained investment.
• Irish GDP partially recovered in Q2 following declines in previous quarters. However, headline GDP remains heavily distorted by pharmaceutical production and is therefore a poor indicator of underlying economic activity. We estimate that growth in modified final domestic demand slowed significantly in Q2 but remained positive at around 1.5% y/y.
• In Turkey, we estimate that GDP growth partially recovered in Q2 following an abrupt decline in exports in Q1, but remained relatively subdued by historical standards at around 3% y/y. Similarly, growth in Kazakhstan picked up to 4.1% y/y as oil production came back online, but remained significantly below last year’s pace.

The labor market remains broadly balanced. Euro area employment growth has slowed to 0.5% y/y in H1 2026, with Spain acting as the main driver in an otherwise subdued labor market. As the slowdown in employment growth has broadly matched weaker labor force growth amid increasingly unfavorable demographic trends, the unemployment rate remained broadly unchanged, hovering near historical lows. However, unemployment continued to fall in Southern Europe while edging up in Germany and the UK. Nominal wage growth in the euro area slowed to 3.3% y/y as real wages have caught up with productivity. CEE economies continue to record much faster wage growth than Western and Southern Europe. At the other end of the spectrum, France and Switzerland stand out with slower wage growth, which is constraining consumer spending.

Oil markets, inflation, central banks and financial markets

Except for a brief partial reopening in June, the Strait of Hormuz has remained closed. Despite the continued closure, oil prices are below their May peaks. Gasoline and diesel prices have fallen much less, however, keeping fuel price inflation elevated. The relatively muted oil price response to the closure of the Strait, given the scale of the shock, can be explained by the rerouting of supplies through Fujairah and the Red Sea, the pre-conflict oil market surplus, weaker oil demand (especially from China) and substantial inventory drawdowns.

Supported by some moderation in oil prices and a decline in food inflation, headline inflation in the euro area fell to 2.9% in July from 3.2% in May. Core inflation remained broadly unchanged at 2.5%, around 0.2 pp above its pre-conflict levels due to some acceleration in core goods inflation. Supply chain disruptions, higher energy and metal prices from the Middle East conflict and AI-related investment are likely to push core goods inflation higher in the coming months.

Cross-country inflation differentials have narrowed in recent months, with most economies recording HICP inflation of around 3% in July. Nevertheless, several exceptions are worth noting:

• Among the major euro area economies, Spain records the highest inflation (3.9% in July) reflecting stronger and accelerating core price pressures. These pressures may be explained by robust domestic demand, which is facilitating a stronger pass-through of the energy shock to consumer prices.
• Romania continues to record the highest inflation in the EU (at 8.2% in July) due to broad-based price pressures exacerbated by increases in VAT and fuel prices. Inflation exceeds 4% in Lithuania and Bulgaria, reflecting strong wage growth, high services inflation and (in Lithuania) deregulated electricity prices.
• In contrast, inflation remains low in Switzerland and Sweden (below 1%), followed by Denmark, Czechia, Hungary and Serbia (below 2%) due to a mix of factors: tax and regulated electricity price cuts (Sweden, Denmark, Czechia, Serbia), limited wage growth (Switzerland, Sweden), currency appreciation (Sweden, Hungary), strong food price deflation (Czechia, Hungary, Serbia), and a fuel price freeze (Hungary).
• Disinflation stalled in Turkey following the energy shock, with price growth remaining above 30% y/y. By contrast, disinflation continued in Kazakhstan, where inflation declined to 10.2% in July.

In response to the energy shock, the ECB raised the deposit facility rate by 25 bp to 2.25% in June. The Fed and the Bank of England have kept their policy rates unchanged, as rates in both economies are already above neutral, at 3.75%. In the UK, the decision to remain on hold has also been supported by disinflation in non-energy components. Most other central banks in Europe have likewise kept policy rates unchanged, as falling food prices and regulatory measures have at least partly offset the impact of the Middle East conflict on headline inflation. The central bank of Hungary is an exception, having cut rates by 100 bp to 5.5% amid FX appreciation and low inflation. The central bank of Kazakhstan has also reduced its policy rate by 125 bp to 16.75%, as inflation eased.

Despite cautious monetary policy and the partial reversal of the oil price shock, bond yields have generally continued to trend up, pointing to broader concerns about inflation risks and fiscal sustainability. Nevertheless, credit demand has remained resilient, while exchange rates have been broadly stable in recent weeks. Equity prices have continued to rise in many European economies, particularly in CEE and Southern Europe. By contrast, global equity indices have remained broadly unchanged over the past three months as the AI-related rally has lost some momentum.

GDP Growth Outlook

Under the baseline scenario of gradually moderating commodity prices, we expect underlying euro area growth (excluding Ireland) to rise to 1.2% in 2026 from 1.0% in 2025, as resilience in global trade, AI-related investment and German fiscal stimulus outweigh the effects of the Middle East conflict and US tariffs. Growth should strengthen further to 1.3% in 2027 and 1.4% in 2028 as these headwinds ease. Due to volatility in Ireland, headline euro area growth is expected to slow from 1.3% in 2025 to 0.9% in 2026, before accelerating to 1.5% in 2027-28.

Country highlights:

• Germany: After export- and government spending-led growth over the past three quarters, momentum is likely to soften in H2 2026 as exports slow and the Middle East conflict weighs on demand. Growth should reaccelerate in 2027-28 as external headwinds diminish. Structural competitiveness challenges and demographic headwinds will continue to constrain growth, with GDP projected to rise 0.9% in 2026, 1.0% in 2027 and 1.3% in 2028.
• UK: GDP is expected to stagnate through the remainder of 2026 as the Middle East conflict restrains consumption and investment, with growth averaging 1.0%, down from 1.3% in 2025. A gradual recovery is expected thereafter, with growth accelerating to 1.3% in 2027 and 1.5% in 2028.
• France: Following stagnation in H1 2026, momentum should gradually improve, initially driven by exports and later by stronger consumption and investment as sentiment improves and real incomes rise. Growth is projected at 0.7% in 2026, increasing to 1.1% in 2027 and 1.4% in 2028.
• Italy: After relatively strong growth over the past four quarters, momentum is expected to stall in H2 2026 as the Middle East conflict weighs on consumption, investment and exports. From 2027, quarterly growth should return to its estimated potential pace of around 0.2%. GDP is forecast to expand by 0.6-0.7% in 2026-2028, broadly matching the previous two years.
• Spain: Growth should remain strong at 2.7% in 2026 before slowing to 2.0% in 2027 and 1.6% in 2028 as support from immigration, tourism and housing gradually fades.
• Rest of Western Europe: Dutch growth is expected to remain close to potential at 1.3-1.5% in 2026-28. In Switzerland, following an export-driven but broad-based acceleration in Q2, we expect growth to average 1.9% this year before moderating to 1.6% in 2027 and 1.3% in 2028. In Ireland, pharma-driven weakness is expected to push GDP down 5.9% in 2026, before rebounding by 7.1% in 2027 and 3-4% thereafter. Modified final domestic demand in Ireland is expected to slow to 2.2% in 2026 before strengthening to 3-4% from 2027.
• Nordics: Following strong growth in 2026 (Denmark 3.6%, Sweden 2.5%, Finland 2.2%), GDP growth is expected to ease toward 1.5-2.0% as cyclical recovery and pharmaceutical sector expansion moderate. In Norway, growth may improve slightly from 1.3% in 2026 to 1.5% in 2027-28 as mainland activity strengthens while hydrocarbons slow.
• Poland: Poland is expected to remain the fastest-growing large European economy, with GDP rising by 3.9% in 2026, supported by real income gains, NextGenEU funding and defense investment, before slowing toward 2.5-2.7% in 2027-28 as public investment plateaus and demographic constraints increasingly weigh on potential growth.
• Other CEE economies: Growth will remain uneven and modest on average in 2026, reflecting contraction in Romania, slower growth in Czechia, Bulgaria and Croatia partly because of the effects of the Middle East conflict, and recovery in Hungary and Serbia. From 2027, growth should strengthen and remain in the 2-3% range, supported by rising real incomes and an industrial recovery.
• Turkey: Growth is projected to slow from 3.6% in 2025 to 2.8% in 2026 as the Middle East conflict weighs heavily on activity, before accelerating to 4.2% in 2027 as investment and exports recover. Thereafter, annual growth should stabilize at around 3.5%.

Monetary Policy Outlook

We expect one further ECB hike in September, followed by a reversal of this year’s tightening in H2 2027. Most other central banks should remain on hold through year-end and resume easing in 2027.

• ECB: We expect one 25 bp rate hike in September. Given our expectations of inflation returning to 2% as early as Q2 2027 and core inflation beginning to subside in the second half of 2027, we expect the ECB to cut the deposit rate back to 2% in H2 2027.
• Fed: While we continue to expect the Fed to remain on hold in 2026 before delivering 50 bp of cuts in 2027 as inflation normalizes, recent hawkish communication increases the likelihood of a rate hike this year.
• BoE: Given easing underlying price pressures, we expect the BoE to keep rates unchanged in 2026, before delivering 50 bp of easing in 2027 when headline inflation normalizes.
• SNB: With inflation remaining low, we expect the policy rate to stay at 0% through end-2029.
• Sweden: Rising core inflation and higher ECB rates should prompt a 25 bp hike in early 2027. As CPIF inflation falls below 2% in 2028, the policy rate may subsequently decline toward 1.75%.
• Norway: We expect one final 25 bp hike to 4.5% in September, followed by gradual easing to 3.75% by end-2027 as inflation falls.
• CEE: Apart from Hungary, we expect central banks to stay on hold this year before resuming easing in 2027.
  • Poland: We anticipate the National Bank of Poland (NBP) to keep the reference rate unchanged at 3.75% this year, given that core inflation is projected to rise toward 3.5%, preventing easing. Rate cuts are possible in 2027 after core inflation begins to decline, with an estimated terminal rate of 3.25%.
  • Czechia: Despite the CNB’s hawkish stance, low inflation should make further hikes unlikely. Rates may be cut to 3.5% by late 2027 as core inflation eases.
  • Hungary: Low inflation and a stronger forint should allow rates to fall to 5.0% by year-end, followed by a pause in H1 2027. We see the terminal rate of 3.75%.
  • Romania: Persistently high inflation is likely to keep rates unchanged through year-end. Easing should resume in early 2027, with rates falling to 4.75% by end-2027 and 3.75% by end-2028.
  • Serbia: With core inflation projected to rise above 5%, household demand receiving additional fiscal support, and credit growth remaining strong, the NBS is likely to keep the policy rate at 5.75% until the second half of 2027 and ease only gradually thereafter, once domestic price pressures begin to recede.
• Turkey: We expect the TCMB to align its 40% funding rate with the official 37% policy rate by year-end by reinstating one-week repo auctions. Rate cuts should start in 2027, reaching 24% by end-2027 and 15.5% by end-2028.

Key forecast drivers and risks

The balance of risks remains skewed toward higher inflation and interest rates and lower GDP growth.

The Middle East conflict remains the main near-term risk. The Strait of Hormuz remains closed and progress in US-Iran talks has been limited. The impact on oil and gas prices has so far been contained by inventory drawdowns, weak demand (especially in China) and the pre-conflict oil surplus. However, if the closure persists, these factors may fade, triggering a stronger rise in commodity prices. Conversely, a full reopening could lead to a faster-than-assumed decline in oil prices, although the potential upside to growth appears smaller than the downside risk associated with a renewed commodity price spike.

To illustrate these risks, we constructed three scenarios:

• Optimistic scenario: oil prices quickly fall to USD 68-70/bbl.
• Adverse scenario: oil prices return toward USD 100/bbl and then decline gradually.
• Severe scenario: oil prices rise above USD 140/bbl in the short term and remain close to USD 100/bbl over the medium term.

Under the optimistic scenario, euro area inflation would be 0.6 pp lower and GDP growth 0.2 pp higher in 2027 than in the baseline scenario. Under the adverse scenario, euro area HICP inflation would be 1.3 pp higher and GDP growth 0.4 pp lower. Turkey would be most affected, followed by Czechia, Romania and the UK, while the Nordics, Poland and the Netherlands would be least impacted. Under the severe scenario, euro area inflation would peak at close to 6%, and GDP growth would be 0.8-0.9 pp lower in both 2027 and 2028 compared to the baseline scenario.

AI is another key driver of the outlook. AI is already influencing activity through investment, trade and equity prices and may have contributed to the productivity revival in the US. Although the effects of AI are most evident in the US and several Asian economies, Europe is benefiting indirectly from stronger global trade. Over time, AI-driven productivity gains will be crucial in offsetting adverse demographics. We estimate that AI may already have raised Europe’s productivity by around 0.2% and assume 0.4% of additional gains by 2029. Risks are tilted to the upside. Conversely, if AI leads to labor displacement, the impact on GDP may be reduced.

Other important sources of uncertainty include:

1. Fiscal policy: Germany’s fiscal package is being implemented, but the pace, scale and economic impact remain uncertain. The timing and design of measures to cushion higher energy prices affect near-term inflation. Further risks arise from high fiscal deficits, political instability and elections in countries including France, Poland and Romania.
2. Tariffs and trade policy: Global trade has remained resilient despite US tariffs, supported by AI-related trade, and the tariff framework has stabilized. Nevertheless, tariffs remain a source of uncertainty due to potential legal challenges, their use in political negotiations, and uncertainty over their durability beyond the next US presidential election.
3. Exports and competitiveness: European exports underperformed global trade in 2024-25, particularly in Germany and France. While we expect export growth to accelerate, the shift toward AI-related goods and a structural loss of industrial competitiveness may prolong Europe’s underperformance and weigh on GDP growth.
4. Equity prices: US equity valuations are elevated by historical standards and, by some measures, are approaching levels observed during the dotcom bubble. If expectations of AI-related earnings growth are not realized, the risk of a significant market correction would increase. Although European valuations remain considerably lower and stock markets play a less important economic role, a major US market downturn would affect Europe through weaker external demand and sentiment, as well as tighter financial conditions. We estimate that a dotcom-style equity market downturn could reduce euro area GDP by 0.6%.
5. Demographics and migration policy: Europe’s unfavorable demographics, tighter migration policies and political resistance to immigration weigh on growth prospects. However, immigration and labor force participation have continued to surprise on the upside. The EU’s working-age population is currently 1.6% higher and its labor supply 2.3% higher than we projected four years ago, suggesting upside risks to our baseline assumption of broadly stagnant labor supply through 2029.

Conclusion:

Europe’s economy has weathered recent shocks better than expected, supported by resilient trade, AI-related investment and Germany’s fiscal expansion. As energy-price pressures fade, growth should gradually accelerate and inflation return to target, allowing monetary policy to ease from 2027. However, the outlook remains fragile: a prolonged closure of the Strait of Hormuz, renewed commodity price spikes, deteriorating competitiveness or an AI-related equity-market correction could result in higher inflation and weaker growth.