Euro Area: Balancing higher inflation with weaker growth

Danske Research Team Danske Bank A/S

The euro area's economic growth faltered in the first quarter of 2026, with GDP expanding by just 0.1% q/q, falling short of the ECB's projection of 0.3% q/q. The economy thus entered the energy shock on a weaker than expected footing. In April, the composite PMI also highlighted a weaker state, slipping into contraction territory at 48.6. The service sector was the primary drag, with its PMI declining further to 47.4 in April. This contraction in the euro area's largest economic sector is a worrying signal for overall growth. The manufacturing sector provided a modest surprise, as its PMI rose to 52.2. This improvement was partly driven by longer delivery times, although output and new orders remained above the 50-threshold. While manufacturing's resilience offers some reassurance, the broader economic picture remains subdued, with growth expectations moderating.

The service sector has shown unexpected fragility in recent data, as its PMI pointed to contraction and several other surveys revealed declining business confidence in the service and retail sectors. Employment indicators have softened, as hiring intentions fell in the EC's business survey, raising concerns about the sector's resilience. Labour market data showed euro area unemployment declining to 6.2%, while low unemployment could be seen as hawkish, moderating labour demand reflected in lower vacancy ratio and declining employment expectations suggest a more balanced labour market compared to 2021-22. This is one reason we only expect two hikes by the ECB and a relatively swift reversal in 2027.

Euro area HICP inflation rose to 3.0% y/y in April from 2.6% in March. The increase was mainly driven by energy inflation, which surged to 10.8% y/y. However, core inflation eased slightly to 2.2% y/y suggesting limited spill-over effects from the Iran war to core inflation so far. The EC's April business survey highlighted a historic spike in selling price expectations within the industrial sector, marking the largest monthly increase in the survey's 25-year history, yet we remain below 2022 levels. While price expectations in services also rose, the increase was more muted compared to 2022 levels, offering the ECB some temporary relief. Finally, consumers have also sharply increased their price expectations for the next 12 months, adding to the very steep March increase (see chart). This rise in expectations poses a challenge for the ECB, as it seeks to balance higher inflation with weaker growth.

The ECB left its policy rates unchanged in April as widely expected, with the deposit rate at 2.00%. The ECB stated that both the upside risks to inflation and downside risks to growth have intensified. We continue to expect the ECB to increase policy rates by 25bp in June and July, respectively, as they clearly communicate an inflation risk bias. For more details see ECB Review - An ocean of uncertainty, 30 April.

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Author

Danske Research Team

Danske Bank A/S

Research is part of Danske Bank Markets and operate as Danske Bank's research department. The department monitors financial markets and economic trends of relevance to Danske Bank Markets and its clients.

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