Eurozone Inflation to Drop Below 2% Amid US Tariffs Impact

By: Payel

Published on: May 20, 2025

Introduction

Eurozone inflation is on track to fall below the European Central Bank’s (ECB) 2% target by mid-2025, driven chiefly by the ripple effects of U.S. trade policy, according to the European Commission’s spring economic forecast published on May 19, 2025. The report—part of Brussels’ regular macroeconomic projections—paints a picture of cooling price pressures across the euro area as consumer-price growth eases to 2% next year and averages just 1.7% in 2026. While this development would mark a welcome achievement for the ECB, it also raises fresh concerns about growth dynamics, competitiveness, and downside risks to the outlook.

European Commission Forecast: Key Highlights

• Inflation trajectory: Headline inflation is projected to slow from 3.1% in 2024 to 2% by mid-2025, dipping below the ECB’s price-stability mandate for the first time since 2021. In 2026, inflation is forecast to average 1.7%.


• Growth outlook: Real GDP growth is seen at 0.9% in 2025, picking up to 1.4% in 2026—above earlier projections by both the ECB and the International Monetary Fund (IMF).


• Unemployment: The euro area jobless rate is expected to decline to 5.9% in 2025 and further to a historic low of 5.7% in 2026, underscoring labour-market resilience despite moderating economic momentum.


• Trade assumptions: The baseline scenario assumes U.S. tariffs on most EU imports remain at 10%, with 25% duties on automobiles, steel, and aluminium continuing, while maintaining exemptions for pharmaceuticals and microprocessors.

“Inflation is declining faster than previously forecast and is on track to reach the 2% target this year,” said Valdis Dombrovskis, European Commissioner for Economy. “But we cannot be complacent. The risks to the outlook remain tilted to the downside, so the EU must take decisive action to boost our competitiveness.”

Drivers of the Inflation Slowdown

Several “clearly negative” forces are set to push inflation lower:

1. Lower energy prices

• The Commission expects oil and gas costs to remain subdued, partly owing to improved supply conditions and weaker demand in key Asian markets. Lower wholesale energy tariffs will weigh on household utility bills and producer input costs, reducing headline CPI.

      2. Diversion of Chinese exports

• As U.S. tariffs make Chinese goods less competitive stateside, producers have redirected shipments to Europe. While beneficial for consumer choice, this influx of lower-priced imports exerts downward pressure on goods inflation across the EU.

     3. Stronger euro exchange rate

• Since early 2024, the euro has appreciated by nearly 8% against the U.S. dollar, making imported goods and commodities cheaper in euro-denominated terms. The currency’s strength also dampens imported inflation for businesses reliant on dollar-priced inputs.

Combined, these factors are forecast to bring goods inflation close to 0% in the euro area by 2026. Services inflation, by contrast, is expected to slow only gradually—from 3.1% in 2024 to 2.5% at the end of 2026—driven by sticky wage growth and strong domestic demand for personal and professional services.

Impact of U.S. Tariffs on Eurozone Prices

The spring forecast places particular emphasis on the impact of U.S. tariffs on EU exports and inflation dynamics. Since 2022, Washington has imposed a 10% levy on a broad swath of European goods, with steeper 25% duties on cars, steel, and aluminium. The European Commission’s analysis finds:

• Competitive pressure: Many European exporters face a 10% cost penalty, forcing them to either absorb lower margins or pass on price increases to U.S. buyers. This erosion of competitiveness has contributed to weaker producer price indices in the euro area.


• Counter-tariff readiness: Brussels has prepared a list of retaliatory measures covering roughly $20 billion in annual imports, should transatlantic talks collapse. The threat of counter-tariffs, while aimed at preserving EU market share, also injects uncertainty into investment and trade decisions.


• Consumer-goods markets: The tariff-induced diversion of Chinese and other non-U.S. exports into Europe intensifies competition among retailers and wholesalers, further compressing mark-ups and softening consumer-price growth.

The baseline forecast, assuming no additional trade escalations, projects that the current tariffs will continue to subtract roughly 0.3 percentage points from eurozone inflation each year through 2026.

Energy Prices and the Chinese Export Diversion

Beyond tariffs, the Commission highlights two other major disinflationary currents:

• Benchmark oil prices: Having averaged around $85 per barrel in 2024, Brent crude is projected to trade near $75 in 2025 and $70 in 2026, reflecting modest global demand growth and resilient non-OPEC supply. Lower fuel costs translate to cheaper transport and manufacturing inputs across the euro area.


• Trade reorientation: Chinese exporters, confronted with U.S. levies, have increased shipments to Europe by an estimated 12% year-on-year. Major product categories include electronics, machinery, and textiles—areas where European manufacturers already face competition from Asia. This shift exerts sustained downward pressure on core goods inflation, which is forecast to approach zero by the end of 2026.

These forces underscore the interconnectedness of trade policy, exchange rates, and global supply-chain realignments in shaping local price pressures.

Exchange Rate Effects and the Stronger Euro

The euro’s appreciation against the dollar and major currencies has played a pivotal role in moderating imported inflation. Key observations:

• Trade-weighted strength: The euro has gained roughly 6% on a trade-weighted basis since mid-2023, making non-euro-area imports more affordable.


• Household purchasing power: A stronger currency reduces the domestic cost of imported electronics, apparel, and raw materials, indirectly supporting real incomes and consumer confidence.


• Policy interplay: While a robust euro feeds into lower inflation readings, it also complicates the ECB’s monetary-policy calculus by amplifying disinflationary impulses beyond the central bank’s direct control.

The forecast warns that if the euro remains elevated, it could shave an additional 0.2 percentage points off headline inflation by mid-2026, reinforcing the downward trend.

Services Inflation and Labour-Market Resilience

Despite the broad disinflationary backdrop, service-sector prices are proving stickier:

• Wage growth: Eurozone wage settlements have averaged near 3.2% annually in 2024, supporting household incomes but also sustaining upward pressure on costs in sectors like hospitality, transport, and professional services.


• Employment dynamics: With unemployment projected to fall to 5.7% in 2026, tight labour markets could prompt further wage demands, maintaining services inflation around 2.5% at year-end.


• Domestic demand: Structural factors—such as demographic shifts toward an older population—and pent-up demand for leisure activities post-pandemic continue to underpin service-price resilience.

Policymakers will need to monitor wage–price spirals carefully, as prolonged services inflation could complicate the ECB’s efforts to achieve a balanced price-stability environment.

Economic Growth Outlook

On the growth front, the Commission’s spring forecasts are modestly more optimistic than previous estimates:

• 2025 slowdown: The euro area faces headwinds from weaker global demand, tighter financing conditions, and trade-policy frictions.


• 2026 rebound: A gradual recovery in global trade, easing energy costs, and supportive fiscal measures—particularly investment in green technologies—should lift growth to 1.4%.


• Fiscal stance: Several member states plan moderate fiscal expansion in 2026, focusing on digital transition and infrastructure, which could boost domestic demand.

While the growth outlook has improved relative to earlier readings by the ECB and IMF, the Commission cautions that upside potential may be limited by structural challenges, including low productivity growth and demographic headwinds.

Risks and Policy Uncertainty

The forecast embeds several downside risks:

1. Escalation of trade tensions: Failure to resolve tariff disputes could trigger new levies, further disrupting supply chains and investor confidence.


2. Global growth slowdown: A sharper-than-expected deceleration in China or the U.S. would dent demand for eurozone exports.


3. Energy-market shocks: Renewed geopolitical tensions in energy-producing regions could reverse the current disinflationary trend in oil and gas prices.


4. Financial volatility: A reversal of search-for-yield flows into emerging markets could destabilize global credit conditions, feeding back into euro area financing costs.

Dombrovskis warned that “policy uncertainty remains high,” urging EU institutions to pursue structural reforms that enhance competitiveness, productivity, and resilience to external shocks.

ECB Response and Monetary Policy Outlook

The European Central Bank will publish its next quarterly staff projections on June 5, alongside its monetary-policy decision. Market consensus points to:

• First rate cut: Many analysts expect the ECB to begin cutting the deposit rate from 3.75% in mid-2025, as inflation approaches target and growth remains subdued.


• Communication focus: ECB President Christine Lagarde is likely to emphasize data dependency, stressing that any easing will be gradual and conditional on inflation developments.


• Balance-sheet strategy: Discussions continue on whether to reinvest maturing assets under the asset-purchase programme, which could provide additional accommodation if needed.

Given the Commission’s forecast of sub-2% inflation and resilient employment, the ECB faces a delicate balancing act: ensuring headline inflation stabilizes at 2% without undermining the post-pandemic recovery.

Conclusion

The European Commission’s spring economic forecast underscores a turning point for eurozone inflation as disinflationary forces—including U.S. tariffs, lower energy prices, and a stronger euro—drive consumer-price growth back to the ECB’s 2% goal by mid-2025. While headline inflation is set to ease conspicuously, services inflation and upside risks from policy uncertainty warrant vigilance. Growth is expected to gently accelerate in 2026, but the euro area must guard against renewed trade tensions and global slowdown risks. With the ECB poised for potential rate cuts, policymakers face tough decisions on how to sustain recovery, foster competitiveness, and secure price stability in an evolving global environment.