European Central Bank — Economic Bulletin (Europe, 2025)

Economic Bulletin Issue 6 / 2025 Contents Economic, financial and monetary developments Overview External environment Economic activity Prices and costs Financial market developments Financing conditions and credit developments Fiscal developments 1 2 3 4 5 6 Boxes 1 2 3 4 5 6 How vulnerable is the euro area to restrictions on Chinese rare earth exports? Consumer expectations and actions during the recent trade tensions Manufacturing versus services: how frontloading and uncertainty shaped recent developments Are workers willing to accept pay cuts in exchange for remote working flexibility? Monitoring attention to inflation in the news Liquidity conditions and monetary policy operations from 23 April to 29 July 2025 Articles 1 Macroeconomic impacts of higher defence spending: a model- based assessment Box 1 Fiscal multipliers of defence spending: a short review of the empirical literature 2 Keep calm and carry cash: lessons on the unique role of physical currency across four crises Statistics Economic Bulletin, Issue 6 / 2025   Contents 2 2 7 12 19 26 31 37 40 40 47 52 57 62 69 74 74 90 95 S1 1 Economic, financial and monetary developments Overview At its meeting on 11 September 2025, the Governing Council decided to keep the three key ECB interest rates unchanged. Inflation is currently at around the 2% medium-term target and the Governing Council s assessment of the inflation outlook is broadly unchanged. The September 2025 ECB staff macroeconomic projections for the euro area present a picture of inflation similar to that projected in June. They see headline inflation averaging 2.1% in 2025, 1.7% in 2026 and 1.9% in 2027. For inflation excluding energy and food, they expect an average of 2.4% in 2025, 1.9% in 2026 and 1.8% in 2027. The economy is projected to grow by 1.2% in 2025, revised up from the 0.9% expected in June. The growth projection for 2026 is now slightly lower, at 1.0%, while the projection for 2027 is unchanged at 1.3%. The Governing Council is determined to ensure that inflation stabilises at its 2% target in the medium term. It will follow a data-dependent and meeting-by-meeting approach to determining the appropriate monetary policy stance. In particular, the Governing Council s interest rate decisions will be based on its assessment of the inflation outlook and the risks surrounding it, in light of the incoming economic and financial data, as well as the dynamics of underlying inflation and the strength of monetary policy transmission. The Governing Council is not pre-committing to a particular rate path. Economic activity The economy grew by 0.7% in cumulative terms over the first half of 2025, on account of the resilience in domestic demand. The quarterly pattern showed stronger growth in the first quarter and weaker growth in the second quarter, partly reflecting an initial frontloading of international trade ahead of expected tariff increases and then a reversal of that effect. Survey indicators suggest that both manufacturing and services continue to grow, signalling some positive underlying momentum in the economy. Even if demand for labour is softening, the labour market remains a source of strength, with the unemployment rate at 6.2% in July 2025. Over time, this should boost consumer spending, especially if, as foreseen in the September 2025 projections, people save less of their income. Consumer spending and investment should benefit from the Governing Council s past interest rate cuts feeding through to financing conditions. Investment should also be underpinned by substantial government spending on infrastructure and defence. Economic Bulletin, Issue 6 / 2025   Economic, financial and monetary developments Overview 2 Trade tariffs and related uncertainty contributed to strong fluctuations in economic activity during the first half of 2025, with frontloading of activity, especially in Ireland. The unwinding of these factors in the second half of the year is expected to entail further volatility, blurring signals of the underlying momentum of the euro area economy. In fact, looking through the volatility caused by the fluctuations in Irish data, economic growth in the rest of the euro area was more stable, and it is expected to remain so in the second half of the year. Although the new US-EU trade agreement implies higher tariffs on euro area exports to the United States, it has helped to reduce trade policy uncertainty. The overall impact of the change in the global policy environment will only become clear over time. Later in the horizon economic growth in the euro area is projected to strengthen, supported by several factors. Rising real wages and employment, together with new government spending on infrastructure and defence, mainly in Germany, should bolster euro area domestic demand. Furthermore, less restrictive financing conditions   mainly reflecting recent monetary policy decisions   and a rebound in foreign demand in 2027 are also seen to support the growth outlook. Annual average real GDP growth is projected to be 1.2% in 2025, 1.0% in 2026 and 1.3% in 2027. Compared with the June 2025 projections, the outlook for GDP growth has been revised up by 0.3 percentage points for 2025, reflecting better than expected incoming data and a carry-over effect from revisions to historical data. As not all of the data surprises relate to stronger than previously assumed frontloading of activity, they are only seen to be partly offset in the second half of the year. The appreciation of the euro and weaker foreign demand (in part related to somewhat higher tariffs than assumed in the June projections) have resulted in a 0.1 percentage point downward revision for 2026. The projection for 2027 remains unchanged. The Governing Council considers it crucial to urgently strengthen the euro area and its economy in the present geopolitical environment. Fiscal and structural policies should make the economy more productive, competitive and resilient. One year on from the release of Mario Draghi s report on the future of European competitiveness, it remains essential to follow up on its recommendations with further concrete action and to accelerate implementation, in line with the European Commission s roadmap. Governments should prioritise growth-enhancing structural reforms and strategic investment, while ensuring sustainable public finances. It is critical to complete the savings and investments union and the banking union, to an ambitious timetable, and to rapidly establish the legislative framework for the potential introduction of a digital euro. Inflation Annual inflation remains close to the Governing Council s target, edging up to 2.1% in August 2025 from 2.0% in July. Energy price inflation was -1.9%, after -2.4% in July, while food price inflation declined to 3.2% from 3.3%. Inflation excluding energy and food stayed constant at 2.3%. Services inflation edged down to 3.1%, from 3.2% in July, while goods inflation was unchanged at 0.8%. Economic Bulletin, Issue 6 / 2025   Economic, financial and monetary developments Overview 3 Indicators of underlying inflation remain consistent with the Governing Council s 2% medium-term target. Year-on-year growth in compensation per employee was 3.9% in the second quarter, down from 4.0% in the previous quarter and 4.8% in the second quarter of 2024. Forward-looking indicators, including the ECB s wage tracker and surveys on wage expectations, suggest that wage growth will moderate further. Along with productivity gains, this will help keep a lid on domestic price pressures, even as profits recover from low levels. The new ECB staff projections present a picture of inflation similar to that projected in June. Headline inflation, as measured by the Harmonised Index of Consumer Prices (HICP), is projected to move sideways, at around 2%, for the rest of 2025, and then to drop to an average of 1.7% in 2026 before recovering to 1.9% in 2027. The drop in 2026 reflects a further gradual easing in the non-energy components, while energy inflation is expected to remain volatile, but to rise over the projection horizon, in part because of the start of the EU Emissions Trading System 2 in 2027. Food inflation is expected to remain elevated initially, as lagged effects from past price increases in international food commodities feed through, but to moderate to rates somewhat above 2% in 2026 and 2027. HICP inflation excluding energy and food is expected to fall from 2.4% in 2025 to 1.9% in 2026 and 1.8% in 2027, as wage pressures recede and services inflation moderates, while the appreciation of the euro feeds through the pricing chain and curbs goods inflation. Lower wage growth, as past real wage losses have been recouped, coupled with a recovery in productivity growth, is expected to lead to significantly slower unit labour cost growth. Compared with the June 2025 projections, the outlook for headline HICP inflation has been revised up by 0.1 percentage points for both 2025 and 2026. This is on account of higher energy commodity price outcomes and assumptions, as well as lagged effects from higher international food commodity prices, which more than offset the effects of the appreciation of the euro. For 2027, the lagged effects of the appreciation of the euro are seen to predominate, resulting in a 0.1 percentage point downward revision. Most measures of longer-term inflation expectations continue to stand at around 2%, supporting the stabilisation of inflation around the Governing Council s target. Risk assessment Risks to economic growth have become more balanced. While recent trade agreements have reduced uncertainty, a renewed worsening of trade relations could