The European economy is advancing at a modest pace, with a slight acceleration expected in the coming quarters

Inflation in the euro area has temporarily dipped below the 2% target

After fluctuating around 2.5%, headline inflation in the euro area fell to 1.7% in September, primarily due to a drop in energy inflation caused by lower oil prices and base effects. However, price pressures in other areas have stabilized: services inflation remains close to 4%, driven by elevated wage growth, food inflation fluctuates around 2.5%, and core goods inflation stays close to 0.5%, as disinflationary trends in the goods markets (falling commodity prices, normalizing supply conditions) have largely dissipated. Core inflation, excluding food and energy, has settled just below 3% (2.7% in September).

The impact of energy prices on inflation is expected to diminish quickly, as favorable base effects are excluded from the calculation, bringing inflation back above the ECB’s 2% target. We project services inflation to remain around 4% until the end of 2024 before gradually decreasing towards 3% over the course of 2025 and 2026 as nominal wage growth slows. Core goods inflation is expected to gradually rise above 1% as increased shipping and wage costs put an upward pressure on prices. As a result, core inflation is likely to stabilize around 2.5% in 2025 before decreasing to closer to 2% in 2026. We expect food inflation  to remain around 2.5% in 2025 due to tax hikes and labor cost pressures, before dropping to 2% from 2026 onward, while energy inflation will hover near 0%. Overall, headline inflation is expected to remain slightly above the target in 2025, averaging 2.3%, before falling slightly below the target in subsequent years, averaging 1.7% in 2026 and 1.8% in 2027.

Although the degree of divergence has lessened as inflation has declined, price growth continues to vary across Europe due to differences in wage growth and price regulation. HICP inflation continues to be the highest in Romania (4.8% in September 2024), where 15% nominal wage growth and strong domestic demand keep core inflation above 6%. Other CEE countries, such as Hungary, Croatia, Slovakia, and Poland, also experience strong price pressures, particularly in services, due to wage growth exceeding 10%. However, declining energy prices have brought headline inflation below 3.5% in most of these countries. On the other end of the spectrum, headline inflation has fallen below 1% in Ireland, Italy, and Switzerland, with core inflation also dropping below 2%.

Moving forward, CEE countries are expected to have the highest inflation rates, while the Nordics and Switzerland should experience the least price pressure. In 2025, we project Poland to exhibit the highest inflation in the EU, averaging 5%, as energy prices are deregulated and core and food price pressures remain elevated due to strong wage growth and demand. Inflation in In Hungary, Romania, and Slovakia is expected to exceed 4% for similar reasons. CPI inflation should be lowest in Sweden and Finland, at approximately 0.5%, due to methodological factors–mortgage interest payments are included in the CPI calculation in these countries, and thus, central bank interest rate cuts will significantly reduce inflation. Price growth is also expected to drop below 1% in Denmark, where core inflation has been particularly low, and remain below 1% in Switzerland.

Monetary policy easing across Europe has accelerated following a decline in economic sentiment and the Fed’s 50 bp rate cut

With lower inflation than in previous years and relatively subdued economic activity across most of Europe, central banks have been reducing interest rates, although the pace and timing of easing vary significantly across jurisdictions.

The ECB began a gradual easing cycle by cutting rates by 25 basis points at every other meeting in June and September, balancing sluggish growth and near-target headline inflation against elevated wage growth and services inflation. However, after a more aggressive 50 bp cut by the Fed and worsening economic sentiment indicators, the ECB has accelerated the pace of easing with an additional rate reduction in October. We expect three more consecutive 25 bp cuts by March 2025, as growth falls below the ECB’s previous projections and the balance of risks to growth remains tilted to the downside, while the risks to inflation seem to have shifted towards lower price growth. Given that inflation is forecast to remain slightly above the target and growth is expected to pick up gradually, the ECB is likely to slow the pace of easing afterward, with two more rate decreases in June and September, leaving the deposit rate at 2%. Risks lean towards a faster pace of easing and a lower terminal rate if growth continues to disappoint and inflation turns out lower than expected.

The Bank of England is expected to take a more cautious approach, continuing to ease monetary policy at every other meeting after cutting rates from 5.25% to 5.0% in August, as it faces higher wage growth and services inflation amid a stronger economic recovery. We expect the terminal rate of 3.5% to be reached by the end of 2025.

The Swedish Riksbank is reducing rates most aggressively among advanced economies, given rapidly declining inflation and stagnant economic activity. After beginning the easing cycle in May, it is set to implement a significant 50 bp cut in November and reach the terminal rate of 2% by March 2025. Norges Bank is more cautious, with the first rate reduction expected in March 2025, followed by rate decreases at every other meeting.

While the pace and timing of easing differ significantly across CEE, all central banks are expected to cut rates by additional 100-150 bps by 2026. Central banks in Czechia and Hungary have been aggressively easing monetary policy since 2023 and are approaching the end of their cycles. Due to stronger price pressures, the terminal rate in Hungary (5.25%) is projected to be much higher than in Czechia (3%). On the other end, Romania began easing in July and is forecast to cut rates gradually before reaching 5.5% due to elevated inflation. Finally, Poland’s central bank has paused since late 2023 and signals that the easing cycle will restart in March 2025. We expect rates to stop at 4.25% in 2026, above the neutral rate due to strong economic activity. 

The balance of risks to GDP growth continues to lean to the downside, particularly in the short term

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

In the short term, economic activity may be lower due to a prolonged downturn in manufacturing, delayed consumer recovery, and subdued investment.

In our baseline scenario, we expect a modest recovery in European manufacturing, driven by recovering domestic demand, continued improvement in external demand, falling interest rates, and a reversal in the inventory cycle. However, risks are skewed to the downside as the structural loss of competitiveness by European producers, not least due to higher energy prices and increasing competition from China, may be more significant than currently anticipated.

Meanwhile, consumption has been weaker than expected in recent quarters, despite rising real incomes. We anticipate this to change as we move into 2025, but there is a risk of further downside surprises, especially if consumers remain pessimistic about the economic outlook.

Although we already expect a modest to moderate pace of investment recovery, driven by lower interest rates and improving demand, there is a possibility that investment will be even more sluggish, particularly if company profit margins continue to erode. The recovery in housing investment may also be more protracted than expected, given that interest rates will remain well above pre-pandemic levels.

Additionally, the direction of US policy following the upcoming presidential election is a significant source of uncertainty for the European economy. Specifically, the potential introduction of broad-based tariffs on imports from the EU and changes in policy towards the war in Ukraine could significantly impact exports and raise the perceived level of geopolitical risks, reducing consumption and investment.

Geopolitical tensions continue to pose a risk—an escalation in the war in Ukraine or further conflict in the Middle East could lead to spikes in commodity prices, further increase in shipping costs, and renewed bottlenecks in global trade. This could lead to a resurgence in inflation and adversely affect global economic activity, particularly in Europe, which is more vulnerable to global shocks due to its openness.

Unfavorable 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 reduced economic activity.

Finally, with inflation no longer driving revenue growth or helping to reduce debt-to-GDP ratios, the risk of renewed stress in emerging economies’ sovereign bond markets, or those in Southern Europe, remains elevated.

Despite these significant downside risks, there are factors that could positively impact growth. Inflation may turn out lower than expected if services inflation declines faster, core goods inflation remains subdued at close to 0%, or positive supply shocks reduce food inflation. Lower inflation would enhance household disposable incomes and consumption. Simultaneously, it would enable central banks to cut interest rates more rapidly to levels below current expectations, providing an additional boost to investment and consumption.

With improving sentiment and declining interest rates, European consumers may also decide to utilize some of their substantial excess savings accumulated during the pandemic, resulting in stronger GDP growth.

Productivity growth, which has been particularly weak over the past decade, presents another upside risk to the outlook. Tight labor markets should encourage firms to invest more in productivity-enhancing and labor-saving technologies, including automation, robotization, and the potential of generative AI. In a recent series of EY articles, we have shown that AI has significant potential to transform the labor market, boost investment, total factor productivity, and GDP growth, with uneven effects across sectors, but it may also increase inflation and interest rates.

Finally, 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 after 2027, driven by demographic trends, with several countries, particularly in CEE, experiencing earlier and more acute 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 seen significant immigration before the large-scale influx from Ukraine, making immigration projections typically conservative.