EY European Economic Outlook

European Economic Outlook: Trade Deal Eases Uncertainty but Growth Remains Fragile

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5 minute read 23 Oct 2025
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Real GDP growth in the euro area slowed to 0.1% q/q in the second quarter of 2025, following a notable increase of 0.6% in the first quarter. This volatility is largely attributed to tariff frontloading, while the underlying growth trend remains subdued at around 0.2% q/q. Poland and Spain continue to post the strongest GDP growth, while Germany and Italy remain the main laggards. The recent US-EU trade deal has not significantly altered our estimates of the tariff impact, which we still expect to reduce EU GDP growth by approximately 0.5 percentage points next year, with negative effects expected to fade gradually over the long term.

Update on Trade Tariffs

On August 21, the United States and the European Union announced a trade deal that establishes a 15% tariff ceiling on most EU exports to the US. This agreement replaces higher threatened rates, although steel and aluminum exports remain subject to a 50% tariff. Some goods, including aircraft, generic pharmaceuticals, and certain natural resources, are exempted from tariffs.

Despite these developments, our assessment of the overall tariff impact on the EU economy outlined in the previous edition of the European Economic Outlook remains largely unchanged. Tariffs are projected to reduce GDP growth in the European Union by approximately half a percentage point next year, although the negative effects are expected to diminish in the long term. Globally, countries with strong export exposure to the US—such as Vietnam, Malaysia, and manufacturing-intensive European countries, as well as China and Mexico—will feel the most significant impact. In contrast, the effect on Southern European nations is anticipated to be limited. While the US is experiencing a gradual uptick in inflation due to higher tariffs, for the rest of the world, including Europe, tariffs have a disinflationary effect, not least due to lower commodity prices.

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Economic Activity in Recent Quarters

Quarterly growth rates in the euro area have been heavily affected by tariff frontloading, but the underlying pace of activity growth remains muted. Real GDP growth jumped to 0.6% q/q in the first quarter of 2025 as exports surged before expected US tariffs, particularly in Ireland, but slowed to 0.1% in the second quarter as frontloading effects partially reverted. Outside of Ireland, growth in the first half of 2025 averaged 0.2% q/q, similar to 2024.

 

Growth disparities persist, with Ireland recording an exceptionally high GDP growth rate of 18% y/y in the second quarter of 2025 as multinational companies, particularly in the pharmaceutical sector, rushed to frontload US tariffs. Among larger economies, Poland and Spain continued to outperform peers, while Germany and Italy almost stagnated.

 

Private consumption continued to grow, albeit at a somewhat slower pace than in 2024, as tariffs weighed on consumer sentiment. Despite lower interest rates, investment remains stagnant, particularly due to tariff-related uncertainty and stable profits. Exports are similarly flat, in spite of support from tariff frontloading and recovery in global trade, as euro appreciation exacerbated long-standing structural competitiveness issues. Manufacturing growth picked up on the back of tariff frontloading and has caught up with services, with ICT and pharmaceuticals as standout performers. Growth in construction has also accelerated, driven by monetary policy easing and government investment.

 

Labor market indicators suggest cooling momentum, as employment growth slows, vacancy rates decline, and nominal wage growth decelerates. Nevertheless, real wage fund growth remains robust, providing continued support to consumer spending. Despite some labor market cooling, unemployment remains close to historical lows in the euro area, as continued declines in Spain are offset by modest increases in Germany and France.

 

GDP Outlook

The euro area GDP growth forecast for 2025 has been revised up to 1.3%, driven primarily by exceptionally strong growth in Ireland. The drivers of the euro area growth include private consumption bolstered by rising real wages, government spending—including Next Generation EU and military outlays—and the reversal of the inventory cycle, while exports and private investment are hindered by tariffs. Growth is expected to slow down to 1.1% in 2026 due to the negative effects of tariffs, particularly on the Irish economy. In 2027 and 2028, recovery is expected, with growth accelerating to 1.6% and 1.8%, respectively, aided by fiscal expansion in Germany, lower interest rates, and further increases in military spending.

 

The pace of growth remains uneven across countries, though some convergence is expected in the coming years.

  • Among the largest European economies, Poland is set to maintain the strongest growth of 3.3% in 2025 and 3.4% in 2026, driven by robust real income gains, expansionary fiscal policy, and elevated public investment, before gradually slowing.
  • Spain is projected to continue expanding, recording 2.8% growth in 2025, supported by immigration and tourism, but its growth is anticipated to moderate towards 1.5-1.6% by 2027-28.
  • Germany remains effectively in stagnation, with a meagre 0.2% growth anticipated this year. Given the drag from tariffs and gradual implementation of the fiscal package, we expect only a slight improvement to 0.7% in 2026 before growth accelerates above 1.5% in the following years.
  • France’s growth outlook is subdued due to political and fiscal challenges. We expect growth to slow to 0.6% in 2025 before gradually accelerating towards 1.0% in 2026 and approximately 1.5% in 2027-28.
  • The Italian economy is expected to grow slowly, maintaining the 0.5% pace seen last year, with an improvement towards 1.0% in 2027-2028.
  • In the UK, despite a strong start to 2025, growth is forecast to slow from 1.2% in 2025 to 1.0% in 2026 amid headwinds from higher inflation, tariffs, and tighter fiscal policy, before picking up again to 1.5% in 2027.

Inflation Outlook

In the second and third quarters of 2025, euro area headline inflation remained near the ECB target, with the Harmonised Index of Consumer Prices at 2.0% y/y in Q2 and 2.1% in Q3. Core inflation declined modestly to 2.4%, remaining slightly above headline inflation, driven primarily by service prices, whose growth eased to 3.2% in September. Food inflation remains moderately elevated, influenced by lingering supply shocks. In contrast, energy prices remain a disinflationary force due to lower oil prices and euro appreciation.

Inflationary pressures are expected to remain contained, with headline and core inflation staying close to 2% throughout the forecast horizon. In 2026, euro area headline inflation is forecast to drop slightly to 1.8% on the back of a further decline in core inflation, moderation in food inflation, and continued declines in energy prices. In 2027, headline inflation is projected to rise to 2.1%, driven by an increase in energy prices resulting from the planned expansion of the EU Emissions Trading Scheme (ETS), despite a further decline in food inflation.

Inflation disparities across EU countries are notable. Romania remains an outlier with the highest inflation rate—above 8%—due to sizeable indirect tax hikes. Several other Central and Eastern European countries (Slovakia, Croatia, Hungary, Bulgaria, and the Baltics) follow with inflation close to 4%, as strong wage growth and local supply shocks continue to push up core and food prices. The UK is a curious case where utility bill, minimum wage, and social security contribution hikes, alongside still-elevated wage growth, pushed inflation back up to 3.8% in August. On the other side of the spectrum, Switzerland continues to flirt with deflation, while in France, inflation is running around 1% due to subdued wage growth and a drop in regulated electricity prices. Looking ahead, cross-country inflation disparities are anticipated to diminish, with 2026 inflation in the largest economies ranging from 1.5% in Spain to 2.4% in the UK, before converging towards 2% in 2027.

Monetary policy

Major and European central banks generally remain in easing mode, though the pace and timing differ widely across jurisdictions. While some central banks, such as the US Fed or Poland’s NBP, have restarted monetary easing, others have paused in the face of lingering price pressures (e.g., Hungary) or as they approach the neutral rate (the ECB).

The Federal Reserve resumed monetary easing in September, cutting its policy rate by 25 basis points to a range of 4.00–4.25%. Despite inflation remaining above the 2% target, the FOMC prioritized rising risks to its maximum employment mandate. We forecast two more 25 bp rate cuts this year and an additional 50 basis points of easing in 2026.

The European Central Bank (ECB) lowered the deposit rate by a cumulative 200 basis points from its 2024 peak to 2.0% in June. Given inflation close to the target and decent GDP growth, the ECB appears comfortable with its current stance. We expect the ECB to keep rates unchanged, though risks are tilted to the downside should growth disappoint, or inflation fall noticeably below the target.

The Bank of England decided on another rate cut, with the Bank Rate at 4.0% in August, down from 5.25% in 2024. Amid rising inflation, the MPC is likely to adopt a cautious stance for the rest of 2025. While our base case assumes one more rate cut this year, the chances of that happening are finely balanced. In any case, we expect two more rate cuts, bringing the Bank Rate to its estimated neutral level of 3.5% by mid-2026 at the latest.

In light of declining inflation, the National Bank of Poland (NBP) cut interest rates by 125 basis points between May and October, reaching 4.5%. We anticipate two more rate cuts by early 2026, bringing the reference rate to 4.0%. As core inflation is expected to reaccelerate in 2026, the NBP is likely to pause for the remainder of that year before reducing rates further to the terminal 3.5% level in 2027. 

Risks and Structural Challenges

While the US-EU trade deal has reduced immediate trade-related uncertainty, the economic outlook is still shaped by fiscal policy debates, geopolitical risks, and structural challenges. The recent trade agreement has eased concerns about a further escalation of tariffs, lowering overall policy uncertainty. However, trade tensions continue to simmer, and the recent escalation in US-China relations following the imposition of export controls on rare earth metals demonstrates that tariff uncertainty has not disappeared. While the risk of additional unprecedented tariffs has diminished, existing measures remain in place and continue to affect the economy.

Germany’s shift to a more expansionary fiscal policy, with higher infrastructure and defense spending, is expected to support euro area growth. Fiscal debates in several countries, including France, and at the EU level remain important, and exceptions for military spending and NATO commitments may further boost government outlays, though high import intensity will limit short-term benefits.

Geopolitical risks persist. The war in Ukraine continues, and Russia has recently conducted several provocations against the EU and NATO countries. While the conflict in Gaza has recently de-escalated, the geopolitical situation in the Middle East remains tense. Any further escalation of these conflicts could increase uncertainty, drive up commodity prices, and disrupt global trade, making Europe particularly vulnerable.

Although manufacturing activity has picked up in recent months, it is unclear whether this trend will be sustained, as tariffs may lead to renewed stagnation or contraction in 2026. Consumption prospects are uncertain, as high savings have yet to translate into stronger spending, while slowing wage growth and weak sentiment weigh on demand. However, growth could rebound if financing conditions improve and inflation falls further.

The recent surge in asset prices, including US equities and precious metals, has reignited concerns about a potential asset bubble. While valuations in European markets remain reasonable and the European economy is less exposed than the US to asset price swings, a potential market correction would negatively affect Europe through weaker sentiment and spillovers from the US.

In Europe, structural competitiveness challenges persist, exacerbated by high energy costs, euro appreciation, and intensified global competition. There is potential for productivity gains through digitalization and AI, and strong immigration could help address demographic pressures, but much will depend on successful labor market integration.

Overall, while near-term risks appear more balanced following the US–EU trade deal, Europe’s medium-term outlook remains challenged by structural competitiveness gaps, policy fragmentation, and lingering global trade tensions.

About the report

The EY European Economic Outlook is a quarterly report prepared by the EY Economic Analysis Team, led by Marek Rozkrut, Chief Economist for Europe and Central Asia. The report analyzes macroeconomic developments, including economic growth, labor markets, inflation, monetary policy and key risk factors. Each edition of the outlook includes macroeconomic forecasts for European countries and selected major economies. Both baseline and alternative scenarios are presented, with forecasts prepared using a large, integrated model of the world economy.

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