Trade tensions between the US and Europe continue to simmer. Despite the 90-day pause in tariffs and European Union’s efforts to delay countermeasures and offer concessions, the US’ position remains uncertain. In late-May, the US administration threatened to impose a fresh 50% tariff on Europe, which would be effective in July if trade differences are not smoothened out. For now, Europe faces a baseline 10% tariff rates, besides 25% tariff on steel, aluminium, and cars’ exports to the US.

To placate US’ demands, the EU had already offered a deal including plans to purchase LNG and agricultural products, lower the tariffs on cars and industrial goods to zero, and ensured broader economic as well as investment cooperation in strategic sectors. While maintaining a constructive tone, the European leaders have also readied retaliatory measures worth EUR95bn, besides tighter regulations on US tech firms, limiting market access to public procurement projects, amongst others.

The US was the EU’s biggest trading partner in 2024, accounting for a fifth of total extra-EU shipments, with China’s share at ~8%. Pharma and medicinal products are key exports to the US, followed by motor cars, aircrafts and associated equipment. Amongst the member countries, Germany, Ireland and Italy are the largest exporters to the US. Hinging on whether it is a unilateral tariff imposition by the US with minimal response by the trading partners, or US tariffs spurring a symmetric retaliation by all US trade partners, the impact on Eurozone growth could be in the order of ~20-40bp according to the European Commission. A one standard deviation in trade policy uncertainty lowers the median real GDP by 0.2ppt, with the lower tail by 0.8ppt, according to the ECB.  

Frontloading of exports and firm industrial production ahead of the US tariff deadline pushed up German GDP growth up 0.4% qoq at the start of 2025, even as growth was still down 0.2% compared to the year ago. France (up 0.1% qoq) and Italy (0.3% qoq) also posted similar improvements. This outperformance could, however, prove to be short-lived. Germany faces two key shifts this year. Firstly, the new government will have the fiscal headroom to deliver on its promise of jumpstarting infrastructure spending, improving the economy’s competitiveness and increase defence capabilities. Secondly, trade and investment outlook face heightened global uncertainties. These two-way forces are likely to see growth stay flat this year in Germany, while growth in the remaining core-4 countries slows from year before.

For the zone, domestic engines will be expected to partly pick the slack from a weak trade outlook. Households are likely to benefit from easing financial conditions, lower inflation rates, low commodity prices, and improvement in residential construction. Wage growth is underpinned by tight labour markets and improving productivity, while nominal compensation per employee moderates from year before. On the other hand, weaker capacity utilisation in midst of trade tensions and subdued business confidence are key drags. Public consumption and investments could benefit from additional fiscal room on aggregate basis. Factoring in two-way forces, we expect 2025 growth to average 0.8% yoy from 1.0% previously, with 2026 at 1.2%.

Disinflationary pressures are likely to dominate the Eurozone price trend in 2025, in midst of lower commodity prices, potential rerouting of non-energy industrial goods exports towards the Eurozone in midst of heightened US-China trade tensions and EUR appreciation offsetting imported inflationary risks. Retaliatory tariffs might temporarily push up core readings, but we don’t expect a material impact. A need to support growth in the face of global uncertainties and subdued price risks, could convince the ECB to add another 25bp rate cut to our baseline assumption. This will likely take the deposit facility rate to 1.75% by end-2025, at the lower end of the indicative 1.75-2.25% range that the ECB considers neutral.

The EUR has appreciated sharply against the USD as well as its key trading partners this year, as the chart highlights. Contrary to expectations that the European authorities will seek to contain EUR’s rise, ECB Chief Lagarde pitched euro as a viable alternative to the dollar, adding that increasing the international role of the euro can have positive implications for the euro area. Besides allowing the EU governments and businesses to borrow at a lower cost, it would also lower FX fluctuations in the face of more euro-denominated trade and persistent flows. European equities (core-4 and Netherlands) attracted $9.3bn foreign inflows in April 2025 up from $2.0bn in January.

The IMF’s Currency Composition of Official Foreign Exchange Reserves (COFER) survey results show that the share of euro holdings in the allocated reserves stood at 19.8% in 4Q24, marginally below the quarter before, partly due to valuation effects. Achieving the required political consensus for the Euro to assume a larger role as a reserve currency will be necessary, besides other economic factors including a need to step up deficit spending, strengthen security infrastructure, besides the basic tenets likely relative stability in the currency coupled with deep markets/liquidity, medium strength of the bloc’s growth prospects, and credible track record of sound economic policies. While we don’t expect the US dollar to relinquish its role as the dominant reserve currency, Euro’s share might rise at a modest pace in the coming quarters. 

Read our latest view on the EUR in FX Quarterly 2Q 25: Cracks in the USD’s status

To read the full report, click here to Download the PDF.
 

Radhika Rao

Senior Economist – Eurozone, India, Indonesia

[email protected]

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