The US Federal Reserve’s decision to frontload a more aggressive 50bp cut in September affirms that the cycle is turning for global central banks. Inflation has been on the downtrend in the US, as it has been in Europe and the UK, as supply shocks recede, service price pressures wane, and global commodity prices hover benignly. In Japan, supply-side inflation has also eased due to the yen’s rebound and weak global commodity prices, but demand-side inflation is rising due to wage hikes and strengthening wage-price dynamics.

Japan

The Bank of Japan (BOJ) kept the overnight call rate unchanged at 0.25% during its September 20 meeting, aligning with our expectations and market consensus. Governor Ueda indicated the central bank’s patience regarding gradual rate hikes in the coming months, noting that upside inflation risks tied to yen weakness have eased. On the other hand, he expressed confidence in the medium-term wage-driven inflation outlook, predicting continued wage growth following next year’s spring negotiations.

These developments support our forecasts that the BOJ will maintain rates at their current level throughout 2024, with gradual increases to 0.50% in 1Q25 and 0.75% in 3Q25. The earlier-than-expected rate hike at the July meeting triggered an unwinding of yen carry trades, resulting in a decline of over 10% in USD/JPY. With the BOJ addressing the yen’s excessive weakness, the inflation overshoot risk has diminished, reducing the urgency for rate hikes in the near term. Recent data indicate that core CPI inflation has stabilised in the 2.5-3.0% range for four consecutive months as of August.

Solidifying wage-price dynamics will likely encourage the BOJ to gradually raise rates towards a neutral level of 1.00% in the medium term. At the July meeting, a BOJ board member suggested that the central bank could raise the policy rate to around 1% or higher, marking the first time a policymaker has specified a potential neutral rate. Recent data also show base wage growth reaching 2.7% YoY in July, sufficient to sustain inflation at 1.0-1.5%.

The upcoming LDP election on September 27 is another critical event to monitor. Among the nine candidates, the top three based on public polls are former Defense Minister Shigeru Ishiba, former Environment Minister Shinjiro Koizumi, and Minister of Economic Security Sanae Takaichi. Ishiba has endorsed the BOJ’s policy of gradual rate increases, arguing that normalising monetary policy could reduce inflation pressure and enhance industrial competitiveness. Koizumi has not explicitly stated his views on monetary policy but indicated a willingness to carry forward the economic policies of PM Kishida’s administration. Takaichi stands out as the significant outlier, advocating for continued monetary easing and arguing that the recent rate hikes were premature.

Most candidates agree on implementing fiscal spending packages to alleviate rising living costs. Ishiba's economic strategy emphasizes boosting wages to counteract inflation and potentially exempting some goods from the 10% sales tax to assist low-income citizens. Koizumi aims to promote higher wages while expanding support for low-income households and pensioners through cash handouts. Takaichi advocates for strategic fiscal spending to enhance job creation, household income, and consumer sentiment.

Candidates also agree on the need for long-term economic reforms, focusing on digital and green transformation. Koizumi has pledged to accelerate Kishida's policies aimed at fostering dynamic economic growth that adapts to technological advancements, including AI. Ishiba calls for a shift from nuclear power to renewable energy sources like geothermal. Takaichi advocates for strategic fiscal investments in cutting-edge technologies to drive economic growth.

Eurozone

The Eurozone economy expanded 0.3% qoq in 2Q at the same pace as the quarter before, suggesting the economy is recovering from last year’s stagnation. The labour market is resilient, marked by positive wage growth and a low unemployment rate.

An ECB study highlighted the dichotomy of strong employment growth in an environment of weak economic activity. Surveys showed that firms preferred to hold on to workers in the initial phase of a slowdown in economic activity, even as it impacted labour productivity. This also coincided with the government’s short-term schemes to support firms to retain workforce during the pandemic as well as a strong rise in corporate profitability in 2022-23 which provided the headroom for firms to retain headcount. On a cyclical basis, this has led to a decline in labour productivity in the euro area, in contrast to an improvement in the US. The impact of the restrictive policy stance is also likely to gradually dissipate as the ECB embarks on its gradual rate-cutting cycle.

Meanwhile, other activity-based incoming data have been less inspiring, including subdued Ifo indices for the last three months, weakening PMIs, and soft industrial production readings. The Economic Sentiment indicators were boosted by French data in the wake of the Olympics, outside of which sentiments were soft, as reflected in manufacturing order books. Much of the risk is still global, especially in Germany, with risks to demand from key markets, particularly China, trade tensions, and weakening trade competitiveness. There is still considerable heterogeneity amongst the core countries. Activity in the heavyweight German economy has been anaemic, marked by the 0.1% decline in 2Q despite inflation coming off highs. By contrast, Spain continued to lead with a +0.8% qoq increase, followed by France at +0.3%. We maintain our growth forecast at 0.8% yoy this year and 1.2% next.

Bank lending activity is still largely muted, with growth to households and non-financial corporates attracting little momentum. Despite a measured cut, domestic financial conditions are still restrictive, with bank surveys also pointing to softer demand conditions. Cumulative policy rate cuts and positive demand visibility are required to trigger a durable recovery in loan growth.

The inflation environment is meanwhile benign, with August reading easing to 2.2% yoy from 2.6%, with Jan-Aug average at 2.5%. Core inflation was down slightly to 2.8% from 2.9% in July. German inflation for the month was the weakest since March 2021, with the downside magnified by lower energy prices and favourable base effects. However, there are pockets of concern.

Firstly, aggregate Eurozone data shows services inflation has been stickier and is running above the pace of headline inflation. Secondly, real wage growth continues to quicken, with German real wages up for a fifth consecutive quarter. In addition, the domestic unions are expected to push for higher increases in the post-summer bargaining rounds. This is likely to keep the ECB data-dependent, as we highlight below.

The ECB cut its benchmark rates by 25bp for a second time in September, taking the deposit facility rate to 3.5%. In line with past guidance, the ECB lowered the main refi and marginal lending facility rates by a larger 60 bps to 3.65% and 3.90%, respectively, effectively narrowing the corridor to rekindle lending between banks and support the economy amid higher inflation in 4Q. At the September rate review, the ECB President Lagarde cited the evolving inflation-growth trends backing the rate cut. There was no explicit guidance on the path forward besides emphasizing the need to take a meeting-by-meeting approach and staying data dependent.

Updated quarterly staff projections provided limited fresh cues. Growth forecasts were trimmed slightly, while inflation was unchanged. Headline inflation is seen at 2.5% in 2024, 2.2% in 2025, and 1.9% in 2026, as in the June projections. The Eurozone economy is expected to grow by 0.8% in 2024 (in line with our forecast), rising to 1.3% in 2025 and 1.5% in 2026, marking a slight downward revision vs June, mainly owing to a weaker contribution from domestic demand.

Growth conditions warrant further easing, but correction in inflation is likely to be slower amid wage-led pressures and base effect-led distortions as the previous disinflation in energy prices falls out of the annual calculations. With policy communication in July working as planned, the ECB might maintain the status quo in October and crystallise the case for further easing in December, when the next batch of staff forecasts become available. Our forecast path foresees a total 100bp reduction in rates by mid-2025, with half already delivered to date, with a bias for the ECB to do more on sharply disappointing growth surprises.


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