EuroFinance

The euro area economy likely experienced modest growth and the first two months of 2025 saw a continuation of many of the previous year’s trends, according to the March statement from the European Central Bank (ECB).

Manufacturing continues to weigh on economic growth, despite some improvement in survey indicators. High uncertainty, both domestically and internationally, is dampening investment, while competitiveness challenges are putting pressure on exports. However, the services sector remains resilient. Rising household incomes and a robust labour market are supporting a gradual increase in consumption, though consumer confidence remains fragile and saving rates are elevated.

The unemployment rate remained at its historical low of 6.2% in January, and employment is estimated to have grown by 0.1% in the final quarter of 2024. Nonetheless, demand for labour has softened, and recent survey data suggests that employment growth was subdued in the early months of 2025, the ECB noted.

“Uncertainty has increased and is likely to weigh on investment and exports by more than previously expected. But growth should be supported by higher incomes and lower borrowing costs. According to staff projections, exports should also be supported by rising global demand, provided trade tensions do not escalate further,” the statement said.

The ECB has revised its growth projections downward, now forecasting GDP growth of 0.9% for 2025, 1.2% for 2026, and 1.3% for 2027. The downward revisions for 2025 and 2026 reflect weaker exports and ongoing investment challenges, partly linked to heightened trade policy and broader policy uncertainty. The ECB added that rising real incomes and the diminishing impact of past interest rate hikes remain key drivers supporting the anticipated recovery in demand over time.

In March, the ECB implemented a 25-basis-point interest rate cut, marking its sixth reduction since it began easing monetary policy in June last year. This latest cut lowers the ECB’s key rate, the deposit facility, to 2.50%.

The economy is bracing for weaker economic growth in the short term, driven by a slowing services sector and persistent contraction in manufacturing, ECB President Christine Lagarde stated during a December 4, 2024, at the hearing of the committee on Economic and Monetary Affairs of the European Parliament.

Lagarde highlighted a glimmer of optimism, noting that “further ahead, the euro area’s economic recovery should start to gather some steam.” She explained that consumer spending is expected to increase as real incomes rise, and investment is likely to recover once the effects of previous monetary policy tightening subside.

However, Lagarde cautioned that the medium-term outlook remains uncertain, with downside risks looming. Elevated geopolitical risks, particularly threats to international trade, could further undermine the Eurozone’s recovery. The region’s high degree of trade openness and integration into global supply chains leaves it vulnerable to foreign shocks, including potential trade barriers that could affect manufacturing and investment.

Zsolt Darvas, senior fellow at Bruegel, a think tank devoted to policy research on economic issues, acknowledged the underperformance of the Eurozone economy compared to its own potential and to the United States. He attributed this to multiple factors, including high energy prices and geopolitical uncertainty.

“The Eurozone economy has been underperforming both compared to its own potential and also compared to the United States,” he said, adding that the economic impact of the war in Ukraine has been far more significant in Europe than in the US.

Despite this, some organic recovery is expected. “When an economy underperforms relative to its potential, a bounce back recovery itself would help some growth,” Darvas noted, pointing to rising consumer incomes and purchasing power as positive drivers. However, he cautioned that fiscal tightening across EU economies, in line with returning European fiscal rules, would continue to act as a drag on growth.

Impact of US trade policy and political turbulence

Goldman Sachs expects 2025 to be a challenging year for the Eurozone, with much of the growth drag stemming from heightened trade policy uncertainty rather than the tariffs themselves. Trade policy uncertainty measures are already on the rise, the investment bank said in a note.

While the size of any US tariffs is highly uncertain, Goldman Sachs analysis suggests that the negative trade effects are likely to be reinforced by continued structural headwinds in the manufacturing sector, including high energy prices and competitive pressures from China, the same report added. “We expect ongoing fiscal consolidation across the Euro area. We see several reasons for continued growth, rather than a Euro area recession. Growth momentum remains modestly positive; consumption is likely to recover given rising real incomes and elevated savings; and we expect the South to show continued resilience compared with the North.”

On March 12, President Ursula von der Leyen stated that trade relations between the European Union and the United States are the largest in the world, bringing prosperity and security to millions of people. She emphasised that trade has created millions of good jobs on both sides of the Atlantic.

“As of this morning, the United States is applying a 25% tariff on imports of steel and aluminium. We deeply regret this measure. Tariffs are taxes. They are bad for business, and worse for consumers. They are disrupting supply chains. They bring uncertainty for the economy. Jobs are at stake. Prices will go up. Nobody needs that – on both sides, neither in the European Union nor in the United States,” von der Leyen said in a press statement.

She added that the European Union must act to protect consumers and businesses. “The countermeasures we take today are strong but proportionate. As the United States is applying tariffs worth USD 28 billion, we are responding with countermeasures worth EUR 26 billion. This matches the economic scope of the tariffs from the United States.”

“Our countermeasures will be introduced in two steps, starting with April 1 and fully in place as of April 13. In the meantime, we will always remain open to negotiations,” von der Leyen added.

With the new tariffs under a second Trump presidency, concerns have been raised about their impact on the Eurozone economy. Darvas acknowledged the uncertainty but suggested that the direct consequences may be limited.

“If the EU loses some market share in the US because of new tariffs, it might be able to sell those products elsewhere in the world, since US trade relations are expected to weaken with many other countries,” he pointed out, suggesting that shifts in global trade patterns could help mitigate the effects.

He also highlighted an often-overlooked consequence of US trade policy: the impact on exchange rates. If tariffs push US inflation higher, the Federal Reserve may be forced to keep interest rates elevated, strengthening the US dollar. “That in turn would necessitate the Federal Reserve to keep the interest rate higher. That would lead to a stronger US dollar, meaning that the euro would depreciate and if the euro depreciates then it also brings further inflation to the Eurozone,” he explained.

The Eurozone also faces political turbulence, and the weakening of political structures raises concerns about the reduced fiscal consolidation, according to a JP Morgan Asset Management report.

The same report also noted that US trade and industrial policies under the new administration are likely to be unfavourable for Europe. In response, the Eurozone may increase fiscal spending, including investments in defense, to support Ukraine amid expectations of reduced US involvement in the war. However, even with increased European spending, a resolution to the conflict could become more likely in 2025.

Inflation and ECB Rate Cuts

With the ECB beginning to cut rates, many are eager to understand the trajectory of monetary policy in 2025. However, Darvas argued that the focus should not be on the number of cuts but rather on the long-term direction of interest rates.

“The most relevant is what will be, I would say, the medium-term level of the central bank interest rate,” he emphasised. While some rate cuts are expected, he warned against assuming a return to pre-pandemic levels, given persistent inflationary pressures.

Inflation, he explained, has shown signs of re-emerging, albeit not dramatically. “The fight against inflation [is] not over,” he cautioned, adding that real income recovery and wage growth could contribute to sustained price pressures.

ECB has highlighted significant vulnerabilities in financial stability amidst a volatile global landscape, as detailed in its November 2024 Financial Stability Review report.  According to the report, risks to economic growth in the euro area have tilted to the downside, even as inflation nears the ECB’s target of 2%. Recent months have also seen sharp, albeit short-lived, spikes in financial market volatility.

Euro area annual inflation is expected to be 2.4% in February 2025, down from 2.5% in January according to a flash estimate from Eurostat.

Despite the resilience demonstrated by financial markets so far, the ECB warned against complacency. Persistent vulnerabilities, particularly in equity and corporate credit markets, heighten the risk of further volatility. Elevated valuations and concentrated risks in equity markets increase the potential for abrupt corrections. The Financial Stability Review report also flagged concerns about non-bank financial institutions, which could exacerbate market stress due to their liquidity challenges, high leverage, and concentrated exposures if adverse dynamics emerge.

RBC Capital Markets, a global investment bank, forecasts the ECB will continue rate cuts in 25-basis-point increments, expecting the deposit rate to reach 2.25% before a pause.

Capital investment and rising energy prices

Amid these challenges, a brighter outlook for capital investment is emerging. The JP Morgan Wealth Management Outlook 2025 report predicts a pivotal year for capital investment by governments and businesses, as policymakers prioritise growth and companies seize profitable opportunities.

The report identifies four critical areas poised to benefit from this surge in investment:

• The AI value chain
• Infrastructure
• Aerospace
• Defense

Innovative European industrial companies are particularly well-positioned to capitalize on these opportunities, even as traditional manufacturing slows.

Addressing concerns about high energy prices and their effect on European manufacturing, Darvas noted that European companies have long adapted to this reality through efficiency gains.

“European companies are much more energy efficient than U.S. and Chinese companies,” he stated, adding that their ability to operate under high energy costs has historically given them a resilience advantage.

However, energy-intensive industries such as steel and chemicals face growing competitiveness challenges. Policymakers, he said, must decide between subsidizing these industries or allowing them to transition elsewhere.

One possible solution, he suggested, would be to encourage these industries to relocate within Europe to regions with cheaper renewable energy. “We should restructure our industry and focus on higher value-added activities,” he concluded, emphasising the importance of long-term strategic shifts.

 2025 outlook

Looking ahead, Darvas stressed that the Eurozone’s economic trajectory will depend on how well policymakers balance stability with adaptability. “The key challenge is not just short-term recovery but ensuring sustainable growth amid structural shifts,” he noted. While uncertainties persist, he suggested that resilience will come from “strategic investments, policy consistency, and a pragmatic approach to global disruptions.”

The structural outlook for the Euro area economy remains challenging, Goldman Sachs noted. “We currently see Euro area potential growth at 1% but expect trend growth to slow to 0.8% by 2030. However, we see scope for additional EU defence spending and some regulatory harmonisation from next year’, the report added.

RCB Capital Markets observed that in the current environment, rate cuts and increased domestic spending could offer some support for growth, though they are unlikely to create significant momentum. Moreover, European economies remain susceptible to inflation, with domestically driven inflation expected to limit how far both the ECB and the Bank of England can lower rates.

While the Eurozone faces significant headwinds, including geopolitical risks, structural challenges in manufacturing, and trade uncertainties, there are also opportunities for recovery. Rising real incomes, increased capital investment, and targeted fiscal spending could bolster growth in the medium term. However, navigating the complex interplay of these factors will be crucial for the region’s economic trajectory in 2025 and beyond.