Eurozone - After solid momentum, tariffs to cause moderation

The eurozone recorded a solid start to 2025 growing by 0.3% q/q, up from 0.2% in the final quarter of 2024. A clear tailwind was provided by frontloading of US exports. Indeed, frontloading was visible in total trade volumes to the US but also in national GDP figures. In Germany, exports rose by 3.2% q/q, especially in cars and pharmaceuticals, categories that dominate US-German trade. Pharmaceuticals have so far remained exempted from tariffs, but threats voiced by the US administration were likely enough for US companies to secure their supply. As a result, GDP of the bloc’s largest economy expanded by 0.4% q/q, the largest expansion since the recovery from the pandemic. Eurozone growth was not solely trade related. Underlying there was genuine strength with rising domestic demand. Wage growth and the recovery of purchasing power resulted in an expansion of private consumption in member states. And over the quarter we have seen solid momentum across construction, helped by a constructive credit cycle, and services. Looking forward, we expect eurozone growth to slow significantly on the back of US tariffs. Frontloading has been a temporary support, leading to payback in Q2. The international uncertainty is also putting a lid on the further recovery of domestic demand. The May PMI dipping below neutral, signalling a decrease in business activity in the middle of Q2 already flags this. Furthermore, a US-EU deal remains uncertain at this stage, especially after Trump’s latest threats of a 50% tariff on EU imports into the US. However, the US-China de-escalation is a positive for the EZ outlook as it means a lower global supply and demand shock, and greatly reduces the risk of dumping of cheap Chinese goods on Europe’s market. It also suggests the US is mindful of the negative impact of tariffs on its own economy, making a US-EU deal more likely. Further out, in 2026 we see growth accelerating on the back of expansive fiscal policy, especially in Germany.

Inflation for April came in above consensus but in line with our forecast. Headline inflation came in at 2.2%, with core at 2.7%. Headline inflation was weighed by lower energy prices – both by a pass-through of lower oil prices to petrol prices and lower natural gas prices to households. Core inflation saw significant upward pressure from the later timing of Easter this year, which as we had expected, lifted services inflation to 3.9% y/y, driven by higher hotel rates and other travel related costs. This followed a correspondingly downwardly distorted March figure. Looking ahead, the drivers of inflation if anything point downward. First, energy prices are likely to continue weigh on inflation. Second, despite the risk of EU retaliation against US tariffs, any retaliation will likely be more than offset by the demand shock from lower exports to the US. Third, wage growth remains on a clear downtrend. As a result, we expect an undershoot of the ECB’s 2% inflation target by late summer.

With Easter timing the main driver of the core inflation bounce, we expect the ECB’s Governing Council to also look through this temporary hump in inflation. At the upcoming June meeting the ECB will unveil its new projections, which will outline the ECB’s thinking on the tariff impact on growth and inflation. We note that the ECB has recently moved closer to our thinking – that on balance the tariff shock will not derail the disinflationary process. Given our growth and inflation outlook we expect 75bp in additional rate cuts, taking the deposit rate to 1.5% by September.