Euro Area: Back on the Verge of a Recession

In a new Citi Research note, a team led by European Economist Giada Giani looks at the potential impacts of the escalating trade conflict for the euro area, revising forecasts for growth and inflation and considering the risks to those forecasts.

We note that the trade conflict sparked by U.S. tariffs marks the third “once in a lifetime” shock experienced by the European economy in fewer than five years. Having started to slowly normalize following the energy shock, Europe’s economy now faces the prospects of falling back into a recession, leading us to formalize our new euro-area forecasts and lay out potential policy responses.

Global tariffs, global shocks

Our working assumption is that tariffs will remain in place around the levels announced. Some €310 billion in euro-zone exports (excluding energy, pharmaceuticals and cars) are subject to 20% U.S. tariffs, while cars and car parts (€42 billion) are subject to a 25% tariff. Using a midrange estimate for trade elasticity of U.S. import demand, we estimate exports to the U.S. may drop by nearly 50%, implying a hit to total euro-zone exports, including services, of around 4.5 percentage points (pp). That would shave roughly 0.6 pp off gross domestic product (GDP).

But we note that the global nature of tariffs means the global negative demand shock may well amplify this estimated impact. Other EU trading partners would experience similar negative demand shocks if not bigger ones, impacting their own demand for European goods and services. Moreover, a period of prolonged uncertainty most likely awaits as firms try to figure out their new operating environments. Combined with tighter monetary conditions, this suggests investment will be deferred, further weighing on GDP.

Therefore, we’re scaling up our estimate of the negative GDP hit to around 1 pp. This negative impact is likely to show in the data starting with second-quarter GDP, and should last for five or six quarters. We’re lowering our 2025 growth forecast to 0.8% from 1.0% and our 2026 forecast to 0.6% from 1.3%. In this new scenario, sequential growth hovers around 0% for three quarters. 

Inflation and monetary policy

We continue to expect U.S. tariffs will bring disinflation to Europe. Besides reduced demand for European exports, an expected oversupply of tariffed Asian products will likely hit European markets, adding to disinflationary pressures on goods. EU counter-tariffs are unlikely to compensate for this effect. In addition, the recent drop in energy prices and the appreciation of the euro further contribute to lower our inflation profile. All in all, we lower our Harmonised Index of Consumer Prices (HICP) forecasts for 2025, 2026 and 2027 to 2.1%, 1.6% and 1.8%, respectively.

A new economic shock would bring responses from policymakers, but the fiscal space within national budgets is more limited than it was during the pandemic or the energy shock, which we think explains the reluctance to make big fiscal announcements that we’ve seen so far. Fiscal space has been created in Germany but may not be immediately available, as a new government must be sworn in and a new budget law passed. Other policy countermeasures could include positive supply-side measures such as deregulation. But we believe that given weaker confidence, such moves may not fully offset near-term headwinds.

This leaves monetary policy, which we continue to think will not only continue easing in the near term but also have to eventually go all the way to expansionary territory. But this is more reactive than proactive, and can cushion the shock to growth but not offset it.