European Economic Outlook: What Will the Tariffs Bring?

Inflation Outlook

As of April, both headline and core inflation in the euro area remain slightly above 2%, driven by elevated services inflation. Recent declines in commodity prices and euro appreciation have contributed to reduced costs for food and energy products. However, inflation rates across Europe are diverging, influenced by disparities in wage growth and regulatory pricing. Price pressures remain somewhat elevated in most CEE countries, where high wage growth keeps services inflation in the 6-8% range. Conversely, the lowest inflation is found in Switzerland, followed by France, where subdued wage growth has kept services inflation in check and food prices remain stable.

The inflation outlook remains broadly unchanged. We anticipate that euro area headline inflation will hover around 2% throughout 2025. Core inflation is expected to be slightly higher than our previous forecasts, declining to 2.4% y/y by the end of the year, but this will be offset by lower energy prices. Simultaneously, inflation for food, alcohol, and tobacco may remain elevated at approximately 2.9%, driven by past supply shocks and tax increases. By 2026, both headline and core inflation are projected to stabilize around 2% and remain close to these levels throughout 2027 and 2028.

The inflation landscape beyond the euro area exhibits considerable divergence. In CEE, some countries, such as Czechia and Poland, are expected to make progress towards their inflation targets, while others, including Romania and Bulgaria, are projected to remain significantly distant from these targets, primarily due to ongoing core inflation challenges. The Nordic countries and Switzerland are expected to experience the least price pressure, while elevated inflation will continue to present challenges in the Caucasus and Central Asia.

Monetary Policy Outlook

In response to modest GDP growth, stable price pressures, and global trade risks, the European Central Bank (ECB) reduced interest rates by 25 basis points at each meeting this year, bringing the deposit rate to 2.25% in May. We expect two more rate cuts in June and September, with the deposit rate stabilizing at 1.75%.

The Bank of England has implemented a cut-and-hold strategy, reducing rates at every other meeting, with the bank rate reaching 4.25% in May. We anticipate three additional cuts of 25 basis points each over the next three quarters.

The Swiss National Bank continued easing monetary policy, lowering the policy rate to 0.25% in March, with one more cut expected at the next meeting. In contrast, the Swedish Riksbank has maintained its rate at 2.25% since January, while the Norges Bank has kept its rate at 4.5% due to rising food inflation, delaying monetary easing. We expect monetary easing in the Nordics to (re)start in September, with the Riksbank cutting rates to 1.75% by early 2026 and Norges Bank gradually reducing the cost of money to 3% by 2027.

Monetary policy diverges across Central and Eastern Europe, with the Czech National Bank easing monetary policy at a slower pace, possibly nearing the end of its cuts. The central banks of Hungary and Romania have maintained rates at 6.5% since late 2024 amid rising price pressures and political uncertainty and will likely continue this stance until at least Q4 2025. Conversely, the National Bank of Poland cut rates by 50 basis points in May after lower-than-expected inflation, and we anticipate further cuts totaling 75 basis points this year and 100 basis points next year.

The Turkish central bank halted its easing cycle, raising rates by 3.5 percentage points to 46% following the detention of Istanbul’s mayor, which led to capital outflows. Meanwhile, Kazakhstan increased rates by 1.25 percentage points to 16.5% due to rising inflation, likely maintaining this level through the end of the year.

Economic Impact of Trade Tariffs

The U.S. government's shift in trade policy has been a key theme in recent months for both the European and global economies. It will undoubtedly continue to be a significant factor affecting both growth and inflation.

Over the past few months, the US administration has imposed tariffs on imports from China, Canada, Mexico, as well as on steel, aluminum, and motor vehicles. Additionally, a 10% tariff has been applied to most goods from all countries. So far, retaliation from other nations, excluding China, has been limited. Tariffs have been changing rapidly, and while they have been reduced recently, the U.S. expected effective tariff rate remains at the highest level since World War II. As a result of unprecedented volatility in trade policy and the scale of the shock, the perception of uncertainty has increased significantly. The increase in uncertainty and the associated tightening of financing conditions are key channels for the transmission of the trade shock, alongside the direct impact of tariffs on trade.

The impact of tariffs on trade relationships is complex. While uniform tariff rates apply to most countries, effective rates vary considerably due to sectoral exemptions and differences in export structures. The highest trade barriers are faced by China, where initial tariffs exceeded 100% on exports, but ongoing negotiations have reduced this to the estimated effective rate of 25%. In Europe, countries experiencing a significant increase in tariff rates include those with a relatively large share of their exports to the U.S. concentrated in the automotive industry (Slovakia, Hungary) or in the steel and aluminum sectors (Luxembourg, Romania).

Under our baseline scenario, tariffs are projected to reduce GDP growth in the EU by approximately 0.5 percentage points next year. The decline in GDP would primarily result from reduced exports and investment, with a limited impact on private consumption. Additionally, the global economic slowdown and heightened uncertainty are likely to lead to a decrease in commodity prices, particularly oil. This decline, coupled with subdued economic activity, will be disinflationary. Central banks are expected to remain cautious in the short term due to increased uncertainty but may reduce interest rates further in the medium term.

In the long run, the United States and China are expected to be among the economies most affected by tariffs, while the EU is projected to experience only a slight decline in GDP. However, this effect will not be uniformly distributed across industries. Certain EU sectors, such as motor vehicles, iron and steel, and textiles, are likely to be among the most adversely impacted by tariffs.

Balance of Risks

The change in U.S. trade policy has added further uncertainty to an already volatile global landscape. The economic outlook has become increasingly uncertain, with the balance of risks tilting towards lower GDP growth in Europe, while inflation risks have shifted towards more moderate price increases.

Clearly, tariffs represent a key risk factor. A recent threat by President Donald Trump to impose a 50% tariff on goods from the EU indicates that trade uncertainty is here to stay. According to our simulations, in this scenario, the negative impact of tariffs on EU GDP would double compared to our baseline.

The uncertainty surrounding U.S. tariffs raises critical questions about their long-term implications for the global economy. It remains unclear whether these tariffs are merely a one-off incident, albeit spread over several months, or indicative of a fundamental reshaping of the global economy and a regime change in attitudes toward international trade. Should the latter be the case, the potential for further protectionism could lead to significant consequences, including decreased world trade, sectoral reorganization, supply chain transformations, and increased geopolitical tensions.

Even if the return of elevated tariffs is temporary, they still pose considerable risks to the European economy. Companies may choose to frontload production to circumvent additional costs, leading to temporary spikes in both production levels and prices. However, such actions may also result in supply chain bottlenecks, complicating logistics and operational efficiency. Conversely, a decrease in production may occur as a direct consequence of increased trade barriers and reduced external demand, which could be exacerbated by heightened uncertainty regarding long-term economic conditions. This uncertainty may lead to a cautious approach among businesses and consumers, negatively impacting investment and spending decisions.  

In addition to tariffs, several other risks remain present. These include geopolitical tensions (especially the ongoing war in Ukraine and conflicts in the Middle East), cyclical risks (the potential for a prolonged downturn in manufacturing and uncertainty regarding recovery in consumer demand), and structural risks (the loss of competitiveness among EU producers, upside risks from advancements in AI). A new upside risk for growth are changes towards a less restrictive European fiscal policy, particularly in Germany.