In our European Economic Outlook – December 2025, we look at the ways that Europe could meet its growing demand for rare earths, the ongoing impacts of high energy costs on European competitiveness and how more spending on defence and infrastructure could shape the economic outlook for the continent.
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IIn our latest European Economic Outlook we look at the prospects for the European economy for 2025 and 2026, including our analysis of growth prospects, trade outlook, consumer spending, inflation, interest rates and fiscal outlook.
Download the full reportMeanwhile, the ECB is unlikely to change rates, while inflation stays near its 2% target.
Inflation remains near target across Europe as central banks appear close to concluding the current interest rate-cutting cycle. In the Eurozone, headline inflation rose to 2.2% in September— driven by a volatile energy component—while core inflation remained unchanged. Underlying price pressures, particularly in services remain elevated, but are expected to moderate in the near term as consumer caution and weak growth weigh on domestic demand.
We expect Eurozone inflation to fall further, potentially dipping below 2% by year-end. This would likely prompt one final rate cut from the ECB in December, bringing the deposit rate to 1.75%.
European labor markets remain resilient despite recent weak growth and heightened uncertainty, with unemployment rates below pre-Covid levels across many economies. However, labor market strength may be put to the test as weak external demand and trade tensions weigh on business earnings.
While consumer demand has been the primary driver of growth, the outlook is mixed. Households’ savings rates have risen significantly since Covid. As lower interest rates make their fuller impact on households’ finances, and lingering policy uncertainty diminishes further, households’ savings ratio may also decline. While we expect savings ratios to remain above the pre-Covid average, reflecting relatively higher interest rates across the region, the fall in savings intentions could still provide some support to consumer spending. Nevertheless, weak consumer confidence suggests that the higher savings preference may endure.
Growing frictions in international trade show a departure from a century long pattern of declining tariffs and trade liberalization, with the effective tariff in the US rising from 2.4% to 17.4% so far this year, although the actual rate may be somewhat lower due to special dispensations agreed.
Trade deals already announced resolve some of the ongoing uncertainty but imply higher tariff rates than those that prevailed at the start of the year. The EU-US trade deal saw tariffs increase to 15% on most EU exports to the US, whilst steel, aluminium and copper remain at 50%. For some sectors, such as automotive, this represents a tariff reduction, from the 25% tariff rate which had been in place since February.
Overall, KPMG estimates suggest tariffs announced so far could reduce EU GDP by up to 1% by the end of 2026.
Public finances across Europe are under strain from rising spending demands and higher debt servicing costs, increasing pressure for medium-term debt sustainability and fiscal consolidation. In June, NATO members pledged to raise defence spending to 5% of GDP by 2035, with 3.5% earmarked for core defence and up to 1.5% for broader security-related expenditures. While dual-use infrastructure may count toward the latter, meeting the 3.5% core target will likely require additional investment in the coming years. At the same time, ageing populations are driving up demand for health and social care, further burdening already stretched public healthcare systems, as well as raising the costs of state pension provision.
This article was originally published by KPMG UK.
Household spending the key to growth in 2026
The largest contribution to economic growth is expected to come from higher consumer spending. The labour market remains strong, with robust job creation across parts of southern Europe offsetting a weakening labour market in Northern and Eastern economies. Overall, we expect to see relatively strong real wage growth, supporting sustained increases in households spending power over the next two years.
Nevertheless, elevated uncertainty, particularly in countries such as France, is supressing consumer confidence across the region, with savings intentions remain high and a consistent majority of consumers indicating an intention to increase savings dampening the prospects for an acceleration in consumer spending growth in 2026.
Manufacturing faces growing competition and potentially limited uplift from higher defence spending
Despite a greater focus on defence, European industrial production is expected to remain weak, with EU manufacturing PMI pointing at neutral levels following some recovery in 2025. European Commission surveys of firms’ perceptions show order books stabilising but remaining broadly negative, supporting the view that EU manufacturing has reached a trough in output, but that recovery is not yet forthcoming.
Despite weakness in industrial production, overall business activity has maintained solid growth, with composite EU PMI having increased in recent months, driven by a resilient services sector.
Muted inflation signals the end to rate cutting cycle for the major European central banks
Inflation across Europe is returning to target, easing concerns for policymakers and pointing at the end to the current rate-cutting cycle. In the Eurozone, inflation is expected to fall to 1.6% in 2026, below the central bank’s 2% target, due to energy base effects. The ECB is unlikely to respond, viewing this fall in inflation as temporary and maintaining a high threshold for further cuts.
A broadly neutral fiscal stance in 2026?
With capacity constraints limiting the absorption of public funds, fiscal stance could be broadly neutral across Europe in 2026. Fiscal consolidation in countries such as Italy and France is expected to offset expansionary policy elsewhere, especially in Germany.
We anticipate a more expansionary fiscal stance in 2027, as German defence and infrastructure spending gains momentum, while Italy is expected to exit its excessive deficit procedure, allowing for less restrictive fiscal policy, with a potential uplift in defence spending to meet NATO targets.
Certain data included here were provided by KPMG UK.
