While the European economy continues to grow at a modest pace, we still expect a slight acceleration in the coming quarters

Inflation in the euro area is projected to stay slightly above 2% throughout 2025, while remaining above targets in CEE and falling below them in Switzerland and the Nordics.

Euro area inflation has risen above 2% in recent months, but underlying price pressures have remained unchanged. Headline inflation increased from 1.7% in September to 2.4% in December 2024, primarily due to an uptick in energy inflation resulting from base effects. Underlying price pressures have stayed largely unchanged, with services inflation sticky at 4.0% and core inflation at 2.7%. Additionally, significant tobacco excise tax hikes in several countries have contributed to the increase in headline inflation.

We anticipate euro area headline inflation to hover around 2.3% throughout 2025. While core inflation is expected to moderate, reaching 2% by the end of 2025, food and energy components will keep headline inflation above 2%. Core inflation should decline as services inflation finally subsides on the back of slowing wage growth, even though core goods inflation is likely to pick up due to the fading of disinflationary forces in industrial goods markets and the EU’s imposition of tariffs on selected US products in response to Trump tariffs. At the same time, food, alcohol, and tobacco inflation may stay elevated at close to 3%, driven by past supply shocks and tax hikes, and energy prices should modestly increase due to higher natural gas prices. By 2026, headline and core inflation are projected to stabilize around 2%.

Inflation levels and underlying price pressures continue to vary across Europe due to differences in domestic demand, wage growth, energy price regulations, and tobacco excise tax hikes. Romania, for instance, continues to experience the highest inflation rate, close to 5%, propelled by very strong domestic demand and wage growth. Inflation is also elevated in several other CEE countries, where services inflation and wage growth remain high. In Western Europe, Belgium and the Netherlands have the highest inflation rates, largely due to substantial tobacco excise tax hikes. Additionally, in Belgium, energy inflation has quickly responded to recent increases in natural gas prices[1], while in the Netherlands, services inflation remains elevated due to relatively strong wage growth. Conversely, Switzerland’s inflation rate is below 1%, as a strong Swiss franc and subdued wage growth have led to goods deflation.

Looking ahead, CEE countries are expected to have the highest inflation rates, while the Nordics and Switzerland should experience the least price pressure. In CEE, headline inflation in 2025 is anticipated to stay above 3.5% in several countries, driven by persistent services inflation and elevated food price inflation resulting from local supply shocks. Poland is expected to see the highest inflation rate, with a significant tobacco excise hike and an anticipated increase in regulated energy prices pushing inflation upwards. In contrast, a strong Swiss franc and low wage growth will continue to limit price pressures in Switzerland. In Finland and Sweden, methodological issues will bring down headline CPI inflation[2], though underlying price pressures will be relatively weak as well.

In most other European countries, we expect headline inflation in 2025 to stay within the 1.5%–3.0% range. Belgium, the Netherlands, Norway, and Spain are likely to be closer to the upper boundary. In Belgium and Norway, energy prices should increase on the back of recent rises in natural gas prices. In the Netherlands, services inflation is anticipated to remain elevated, while in Spain, price pressures will be broad-based due to relatively strong economic activity. In contrast, food inflation in France should remain lower than elsewhere, keeping headline inflation below 2%.

Monetary policy easing continues at varying pace across Europe, with interest rate disparities likely to persist.

With inflation rates lower than in previous years and economic activity subdued across most of Europe, central banks have continued to reduce interest rates, though the pace and timing of easing vary significantly across jurisdictions.

Amid deteriorating business sentiment, the ECB accelerated the pace of easing in late 2024, implementing three consecutive 25bps rate cuts from September to December, bringing the deposit rate down to 3%. We expect this pace of easing to continue into 2025 Q1. However, as the deposit rate nears policymakers' estimates of the neutral rate and economic activity picks up, the pace of easing is likely to decelerate, especially as the Federal Reserve adopts a more cautious approach to rate reductions. We project a total of 100bps of ECB easing in 2025, with the terminal rate of 2% to be reached by September 2025. Risks are skewed towards a lower terminal rate should economic growth fall short of expectations.

The Bank of England’s Monetary Policy Committee (MPC) has established a “cut and hold” strategy, which we expect to be maintained throughout 2025. The Bank Rate is projected to decrease from 4.75% at the end of 2024 to 3.75% by the end of 2025, eventually settling at 3.5% in Q1 2026.

The Swiss National Bank (SNB), facing a strong Swiss franc, low wage growth, and subdued inflation, reduced interest rates from 1.75% to 0.5% in 2024. We anticipate further cuts to 0% in the first half of 2025. Sveriges Riksbank has also outpaced the ECB in rate cuts, with rates reaching 2.5% by the end of 2024, prompted by stagnant economic activity and weak underlying price pressures. We expect two more rate cuts before the terminal level of 2% is reached. In contrast, somewhat higher inflation keeps Norges Bank more cautious, with gradual (25 bp per quarter) rate cuts expected to start only in March 2025.

In CEE, elevated wage growth and services inflation, along with resurging food price pressures, have prompted central banks to slow or pause rate cuts in recent months. We expect that elevated inflation will prevent more aggressive easing in 2025, with central banks in Poland, Romania, and Hungary projected to reduce rates by 75 bp, leaving rates at a relatively high level of at least 5% by year-end. The return to longer-term nominal neutral rates of 3.5-4% is likely to take several years in Poland and Romania. Czechia stands as an exception, where weaker wage, demand, and price pressures have already led to a drop in interest rates to 4%. We expect the terminal rate of 3% to be reached by 2026 Q1.

The outcome of the US elections has further skewed the balance of risks for GDP growth to the downside and slightly heightened inflation risks.

The economic outlook remains uncertain, with the balance of risks continuing to be tilted towards lower GDP growth in Europe, while inflation risks have shifted towards more contained price increases.

Higher tariffs in global trade present a key risk factor. The potential resurgence of trade wars looms, with D. Trump signaling intentions to impose higher tariffs on imports to the US. This will likely lead to retaliatory actions from other nations. European GDP is expected to suffer in comparison to the status quo, not only due to direct reductions in exports (stemming from tariff-induced price increases and weakened global demand) but also due to the uncertainty tied to potential trade war escalations. Our baseline scenario assumes the imposition of limited tariffs targeting specific products, but risks are skewed towards broader tariffs. Blanket tariffs would pose a substantial drag on the European economy over the medium term, particularly impacting manufacturing-heavy countries such as Germany, Czechia, and Hungary. For more information on the impact of potential tariffs, see our note.

Geopolitical tensions remain a significant concern, with the persistent war in Ukraine and the Middle East continuing to be a potential hotspot for conflicts despite some recent de-escalation. Additionally,  recent signals from the new US administration hint at potential new areas of geopolitical tensions (Panama Canal, Greenland). Any escalations could amplify uncertainty, trigger commodity price spikes, further increase shipping costs, and create bottlenecks in global trade. These developments could reignite inflation and adversely affect global economic activity, with Europe being particularly vulnerable to global shocks due to its high degree of openness.

In the short term, economic activity may also be lower due to a prolonged downturn in manufacturing, delayed consumer recovery, and subdued investment. Risks for the manufacturing outlook are skewed to the downside as the structural loss of competitiveness by European producers, not least due to higher energy prices and intensifying competition from China, may be more pronounced than currently anticipated. Meanwhile, we expect consumers to gradually reduce their currently very high saving rates, and investment to rebound on the back of lower interest rates and NextGenEU spending. However, global uncertainty may negatively affect business and consumer sentiment, delaying the consumer and investment recovery.

Adverse weather conditions or local political unrest could also reduce the supply of or increase demand for energy and food commodities, leading to higher inflation and diminished economic activity. Moreover, with inflation no longer fueling revenue growth or aiding in the reduction of debt-to-GDP ratios, the risk of renewed stress remains elevated in the sovereign bond markets of emerging economies as well as in Southern Europe.

Despite these significant downside risks, several factors could positively influence growth. Inflation may prove lower than expected if services inflation declines more rapidly, core goods inflation remains subdued at close to 0%, or positive supply shocks alleviate food inflation. Lower inflation would boost household disposable incomes and consumption. Concurrently, it would allow central banks to cut interest rates more aggressively to levels below current projections, providing an additional stimulus to investment and consumption.

European consumers may also reduce their saving rates more quickly than anticipated from the presently high levels, or even spend a portion of their substantial excess savings accumulated during the pandemic, resulting in stronger GDP growth. Over the medium term, it is unlikely that the saving rate will stay significantly above pre-pandemic levels, especially as incentives to save diminish with declining ECB interest rates.

Productivity growth, which has been notably weak over the past decade, represents another upside risk to the outlook. Tight labor markets should encourage firms to invest in productivity-enhancing and labor-saving technologies, including automation, robotization, and the potential of generative AI. In a recent series of EY articles, we highlighted AI’s substantial potential to transform the labor market, boost investment, total factor productivity, and GDP growth, albeit with uneven effects across sectors. However, AI may also contribute to higher inflation and interest rates. 

Lastly, strong immigration flows could alleviate demographic pressures and support potential growth. Our baseline scenario predicts that labor supply in Europe will plateau after 2025 and decline post-2027, driven by demographic trends, with several countries, particularly in CEE, facing earlier and more severe reductions. However, tight labor markets in Europe and ongoing global population growth present an upside risk that immigration could at least partially offset these gaps. This scenario appears more plausible in CEE, which had not experienced significant immigration prior to the large-scale influx from Ukraine, rendering immigration projections typically conservative.