GDP growth in the eurozone will be subdued in 2025 but is set to increase thereafter, together with interest rates. Political developments in recent months led to changes in our base-case scenario. We revised our GDP growth forecast for 2025 downward to 0.9%, compared with 1.2% previously, as uncertainty and higher U.S. tariffs on European goods imports should weigh on demand. We believe uncertainty will have a more pronounced effect on GDP than tariffs (see chart 1).

Chart 1

Fiscal stimulus programs should spur GDP growth from 2026, with Germany and the EU planning to increase infrastructure and defense spending. We therefore revised our GDP growth forecast upward by 0.1 percentage points to 1.4% for 2026 and by 0.3 percentage points to 1.5% for 2027. With the output gap set to turn positive in 2027, fiscal stimulus programs will likely increase inflation over the medium term.

We now forecast inflation of 2% in 2026, compared with our previous expectation of 1.8%. We project that the ECB will start raising rates in the second half of 2026, after an expected rate cut to 2.25% in June this year. We expect Germany's 10-year government bond yields will reach new heights and average 2.6% over 2025-2026.

The euro will likely appreciate gradually toward 1.13 in 2027, provided the Federal Reserve starts cutting rates at the end of this year. The rise in real incomes--spurred by strong labor markets, disinflation, and the previous decline in interest rates--should continue to boost consumer spending over 2025-2026, as has already been the case since the second half of 2024 (see chart 2).

Chart 2

Although unemployment is low, we keep a watchful eye on the labor market. Real wages continue to rise faster than productivity, while the increase in unit labor costs (3.5% year on year in the fourth quarter of 2024) was partially offset by falling unit profits (minus 1.2% year on year in the fourth quarter of 2024) over the past 18 months.

The decline in job vacancies to 2.5% of the labor force has not triggered a rise in unemployment yet. The gradual slowdown in job openings continues across Europe (see chart 3).

Chart 3

Many Moving Parts

Our current base-case scenario rests on our assumptions for trade tariffs and fiscal developments, which could change swiftly. For now, the following expectations inform our baseline:

• From midyear 2025, the U.S. Trade Administration is expected to impose reciprocal tariffs on all goods imported from Europe and 10% on autos and pharmaceuticals, in addition to the existing 25% tariffs on steel and aluminum. We do not expect these tariff increases to be reversed any time soon and forecast that the EU's retaliation tariffs will be limited. In our previous base-case scenario, we assumed no tariff increases.
• The fiscal package that the German parliament passed on March 18, 2025, will be executed without too many delays. We assume this package will contribute only 0.1% to German GDP growth this year but expect its contribution will increase gradually to 0.5% in 2026, 0.7% in 2027, and 0.9% in 2028.
• EU member states will agree to increase defense spending by 1% of GDP from 2026. This plan could lift eurozone GDP by 0.1% in 2026, 0.2% 2027, and 0.3% in 2028.

U.S. tariffs could harm the European recovery

At the time of writing, the extent of tariff increases that the U.S. administration will impose on European imports is unclear. We therefore consider different tariff outcomes and estimate their effects on European GDP. Chart 4 reflects the direct effects from tariffs on eurozone GDP via the trade channel that are calculated as the product of the:

• Domestic value added that each manufacturing sector exports to the U.S.;
• Price elasticity of trade by sector; and
• Net increase in tariffs for each sector (see tables 1 and 2).

We have used this methodology in our previous publications. In our base-case scenario of reciprocal tariffs on all goods, 10% tariffs on automobiles and pharmaceuticals, and 25% tariffs on steel and aluminum, we forecast eurozone GDP will decline by almost 0.1%. For the most severe scenario, we expect an increase in U.S. tariffs on all EU imports to 25% would decrease eurozone GDP by almost 0.6%.

In contrast, tariff increases to 10%--in addition to the 25% tariffs on steel and aluminum--would reduce GDP by 0.2%. We note that the tariff-related decline in GDP is a one-off effect that would materialize over the course of four quarters.

Chart 4

Table 1

Table 2

Another potential tariff outcome consists of the U.S. administration targeting EU member states of NATO that run a large trade surplus with the U.S. and do not meet the 2% GDP target on military spending. This outcome would particularly affect Germany and Italy (see chart 5). However, trade policy in Europe is determined at the EU level, not at the country level, which makes this scenario unlikely, in our view.

Chart 5

We note that the EU's retaliation to U.S. steel and aluminum tariffs remains limited and that the EU remains willing to negotiate. At the time of writing, the EU's plan to reinstate tariffs on imports of U.S. boats, bourbon, and motorcycles, among others--which would account for 2% of U.S. exports to Europe--has been pushed back to mid-April, together with other retaliation measures that could affect up to 8% of goods imports from the U.S., if current negotiations fail. The inflationary effects of these potential measures on European consumers would be negligible.

Uncertainty Prevails

Even if tariffs are unlikely to derail the European economy via the direct trade channel, the uncertainty that results from the ongoing deal-making mode of the U.S. administration impairs European demand. We believe the current uncertainty will reduce eurozone GDP by a cumulative 0.4% over 2025-2026. This estimate is based on a methodology by the ECB that considers several facets of uncertainty, in addition to trade uncertainty.

While uncertainty is currently restricted to trade and policy (see chart 6), it is starting to spread to financial conditions. This increases market volatility and could deteriorate economic sentiment and make economic forecasts more volatile.

Chart 6

Despite high policy uncertainty, however, confidence in Europe has started to recover. This rebound resulted from falling interest rates and inflation, as well as the continued strength of the labor market. The expected quick formation of a new government after the German elections and the announcements of fiscal stimulus packages in Germany and at the EU level might have strengthened confidence additionally.

Talks about a potential ceasefire in the Russia-Ukraine war are still at an early stage and are therefore unlikely to have had a positive effect on confidence in Europe. Overall, the correlation between confidence and economic growth decreased over the past two years (see chart 7).

Chart 7

Germany's Fiscal Stimulus Package Is A Game Changer

The incoming German government has proposed spending of up to €900 billion, which is almost 20% of German GDP and about 5% of EU GDP. The money would be spent on infrastructure (up to €500 billion over twelve years, 20% of which would be allocated to the green transition), defense (exempt from the debt brake if defense spending exceeds 1% of GDP), and German states, allowing them to run an annual structural deficit of 0.35% of GDP, compared with zero under the current debt brake.

The German parliament passed the package on March 18, 2025. We believe its effects on the real economy will materialize gradually--historically, the absorption of large public funds in Germany did not exceed 45% after four years. Multiplier effects will be modest (we take the 2018 Bundesbank estimates as reference). We forecast that arms imports will account for a large but declining portion of defense spending over the forecast horizon.

Similarly, EU member states will likely agree to an increase in defense spending by 1% of GDP from 2026. The share of arms imports will be high but decline over the forecast horizon, as the European defense industry's capacity increases (see chart 8). In particular, support from the European Investment Bank should help gradually increase the European defense industry's capacity further.

The Stockholm International Peace Research Institute estimates that the U.S. accounted for 64% of arms imports by European NATO members over 2020-2024, up from 52% over 2015-2019. We forecast that the EU's plan to increase defense spending could boost eurozone GDP by 0.1% in 2026, 0.2% in 2027, and 0.3% in 2028.

Chart 8

Short Break From Rate Cuts

The ECB could start raising rates again in late 2026. As expected, the ECB cut rates at its most recent meeting by 25 basis points (bps) to 2.50%--the sixth rate cut since June 2024. During the press conference, ECB President Christine Lagarde acknowledged that "monetary policy is becoming meaningfully less restrictive."

Indeed, the effective level of the neutral rate remains a matter of debate. While ECB staff recently estimated it at 1.75%-2.25%, empirical evidence suggests that monetary policy stopped impairing demand a couple of months before the most recent cut: Banks that were polled as part of the Bank Lending Survey reported a strong recovery in credit demand, which is clearly reflected in the statistics for new loans to the private sector (see chart 9). Additionally, households have started to save a smaller share of their income and now keep their savings more liquid than before.

Chart 9

We now believe that the ECB will cut rates for the final time in this cycle to 2.25% in April or June. This, and declining inflation, should boost confidence, while the labor market continues to cool. Germany's and the EU's fiscal plans to increase spending on infrastructure and defense will likely push growth sufficiently above its potential to turn the output gap positive by 2027 (see chart 10). In this context, we expect the ECB will start raising rates again in the second half of 2026 and forecast two hikes to a deposit facility rate of 2.75% by the end of 2026.

Chart 10

Look For The Silver Lining

With so many aspects up in the air, the likelihood of our baseline being knocked off course is unusually high. On the growth front, risks remain tilted to the downside:

• Uncertainty about foreign trade could last longer than we currently assume, while the increase in U.S. tariffs could exceed our expectations.
• It is unclear whether trade tensions will result in discussions about the international role of the U.S. dollar.
• The implementation of Germany's fiscal plans the EU's defense plan could be slow or incomplete.
• Peace talks in the Ukraine are in limbo.
• The U.S. economy could face a hard landing due to higher import prices triggered by tariffs, which could have spillover effects on the European economy.
• The European labor market could deteriorate further.

That said, upside risks exist. Our assumptions about the absorption and multiplier effects of the German fiscal stimulus package and the percentage of European defense spending that is allocated to arms imports could be too conservative. We may also be underestimating the effect of the German stimulus program on the eurozone. Finally, the potential fiscal turnaround in Germany or successful peace talks between Russia and Ukraine could increase confidence across Europe.

Related Research

• Europe Must Avoid The Middle Technology Trap To Continue Reaping Free Trade's Rewards, Sept. 5, 2024

External Research

• "Trends in International Arms Transfers, 2024," published by the Stockholm International Peace Research Institute in March 2025.
• "The impact of the recent spike in uncertainty on economic activity in the euro area," published in the ECB Economic Bulletin, Issue 6/2020, in 2020.
• "Fiscal multipliers of central, state and local government and of the social security funds in Germany: evidence of a SVAR," published by Deutsche Bundesbank in 2018.