At its meeting on 18 July 2024, the Governing Council decided to keep the three key ECB interest rates unchanged. The incoming information broadly supports the Governing Council’s previous assessment of the medium-term inflation outlook. While some measures of underlying inflation ticked up in May owing to one-off factors, most measures were either stable or edged down in June. In line with expectations, the inflationary impact of high wage growth has been buffered by profits. Monetary policy is keeping financing conditions restrictive. At the same time, domestic price pressures are still high, services inflation is elevated and headline inflation is likely to remain above the target well into next year.

The Governing Council is determined to ensure that inflation returns to its 2% medium-term target in a timely manner. It will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim. The Governing Council will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction. In particular, its interest rate decisions will be based on its assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. The Governing Council is not pre-committing to a particular rate path.

The incoming information indicates that the euro area economy grew in the second quarter, but likely at a slower pace than in the first quarter. Services continue to lead the recovery, while industrial production and goods exports have been weak. Investment indicators point to muted growth in 2024, amid heightened uncertainty. Looking ahead, the recovery is expected to be supported by consumption, driven by the strengthening of real incomes resulting from lower inflation and higher nominal wages. Moreover, exports should pick up alongside a rise in global demand. Finally, monetary policy should exert less of a drag on demand over time.

The labour market remains resilient. The unemployment rate was unchanged, at 6.4% in May, remaining at its lowest level since the start of the euro. Employment, which grew by 0.3% in the first quarter, was supported by a further increase in the labour force, which expanded at the same rate. More jobs are likely to have been created in the second quarter, mainly in the services sector. Firms are gradually reducing their job postings, but from high levels.

National fiscal and structural policies should aim at making the economy more productive and competitive, which would help to raise potential growth and reduce price pressures in the medium term. An effective, speedy and full implementation of the Next Generation EU programme, progress towards capital markets union and the completion of banking union, and a strengthening of the Single Market are key factors that would help foster innovation and increase investment in the green and digital transitions. The Governing Council welcomes the European Commission’s recent guidance calling for EU Member States to strengthen fiscal sustainability and the Eurogroup’s statement on the fiscal stance for the euro area in 2025. Implementing the EU’s revised economic governance framework fully and without delay will help governments bring down budget deficits and debt ratios on a sustained basis.

Annual inflation eased to 2.5% in June, from 2.6% in May. Food prices went up by 2.4% in June – which is 0.2 percentage points less than in May – while energy prices remained essentially flat. Both goods price inflation and services price inflation were unchanged in June, at 0.7% and 4.1%, respectively. While some measures of underlying inflation ticked up in May owing to one-off factors, most measures were either stable or edged down in June.

Domestic inflation remains high. Wages are still rising at an elevated rate, making up for the past period of high inflation. Higher nominal wages, alongside weak productivity, have added to unit labour cost growth, although it decelerated somewhat in the first quarter of this year. Owing to the staggered nature of wage adjustments and the large contribution of one-off payments, growth in labour costs will likely remain elevated over the near term. At the same time, recent data on compensation per employee have been in line with expectations and the latest survey indicators signal that wage growth will moderate over the course of next year. Moreover, profits contracted in the first quarter, helping to offset the inflationary effects of higher unit labour costs, and survey evidence suggests that profits should continue to be dampened in the near term.

Inflation is expected to fluctuate around current levels for the rest of the year, partly owing to energy-related base effects. It is then expected to decline towards the target over the second half of next year, owing to weaker growth in labour costs, the effects of the Governing Council’s restrictive monetary policy and the fading impact of the past inflation surge. Measures of longer-term inflation expectations have remained broadly stable, with most standing at around 2%.

The risks to economic growth are tilted to the downside. A weaker world economy or an escalation in trade tensions between major economies would weigh on euro area growth. Russia’s unjustified war against Ukraine and the tragic conflict in the Middle East are major sources of geopolitical risk. This may result in firms and households becoming less confident about the future and global trade being disrupted. Growth could also be lower if the effects of monetary policy turn out stronger than expected. Growth could be higher if inflation comes down more quickly than expected and rising confidence and real incomes mean that spending increases by more than anticipated, or if the world economy grows more strongly than expected.

Inflation could turn out higher than anticipated if wages or profits increase by more than expected. Upside risks to inflation also stem from the heightened geopolitical tensions, which could push energy prices and freight costs higher in the near term and disrupt global trade. Moreover, extreme weather events, and the unfolding climate crisis more broadly, could drive up food prices. By contrast, inflation may surprise on the downside if monetary policy dampens demand more than expected, or if the economic environment in the rest of the world worsens unexpectedly.

The policy rate cut in June has been transmitted smoothly to money market interest rates, while broader financial conditions have been somewhat volatile. Financing costs remain restrictive as the previous policy rate increases continue to work their way through the transmission chain. The average interest rate on new loans to firms edged down to 5.1% in May, while mortgage rates remained unchanged at 3.8%.

Credit standards for loans remain tight. According to the July 2024 bank lending survey, standards for lending to firms tightened slightly in the second quarter, while standards for mortgages eased moderately. Firms’ demand for loans fell slightly, while households’ demand for mortgages rose for the first time since early 2022.

Overall, credit dynamics remain weak. Bank lending to firms and households grew at an annual rate of 0.3% in May, only marginally up from the previous month. The annual growth in broad money – as measured by M3 – rose to 1.6% in May, from 1.3% in April.

The interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility remain unchanged at 4.25%, 4.50% and 3.75% respectively.

The asset purchase programme portfolio is declining at a measured and predictable pace, as the Eurosystem no longer reinvests the principal payments from maturing securities.

The Eurosystem no longer reinvests all of the principal payments from maturing securities purchased under the pandemic emergency purchase programme (PEPP), reducing the PEPP portfolio by €7.5 billion per month on average. The Governing Council intends to discontinue reinvestments under the PEPP at the end of 2024.

The Governing Council will continue applying flexibility in reinvesting redemptions coming due in the PEPP portfolio, with a view to countering risks to the monetary policy transmission mechanism related to the pandemic.

As banks are repaying the amounts borrowed under the targeted longer-term refinancing operations, the Governing Council will regularly assess how targeted lending operations and their ongoing repayment are contributing to its monetary policy stance.

The Governing Council decided at its meeting on 18 July 2024 to keep the three key ECB interest rates unchanged. The Governing Council is determined to ensure that inflation returns to its 2% medium-term target in a timely manner. It will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim. The Governing Council will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction. In particular, the interest rate decisions will be based on the Governing Council’s assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. The Governing Council is not pre-committing to a particular rate path.

In any case, the Governing Council stands ready to adjust all of its instruments within its mandate to ensure that inflation returns to its medium-term target and to preserve the smooth functioning of monetary policy transmission.

The Federal Reserve’s (Fed’s) dual-mandate focus has shifted attention to the labor market which appears to be losing steam, stoking fears of a sharper U.S. economic slowdown and triggering a sell-off in risk assets globally.Disappointing data could front-load the Fed’s policy action towards the neutral rate, with markets re-pricing for larger cuts at the remaining FOMC meetings this year.Portfolios should be well diversified across both equities and fixed income, and remain appropriately balanced across both U.S. and global equities.

The broadening focus of the Federal Open Market Committee (FOMC) last week on the labor market put the spotlight on a slew of labor market data that came through last week. Overall, the signals from the incoming data pointed to a labor market that is losing steam rather quickly, bolstering the case for the central bank to deliver its long-awaited monetary policy cut at its meeting next month, on Sept 17-18. This comes as markets have repriced for larger policy rate cuts in subsequent meetings following the conclusion of the FOMC meeting last week. In recent days, we have witnessed large moves across major indices, with the next few months likely proving to be volatile as markets reassess incoming data for guidance on the timing and magnitude of the policy rate cuts.

While the Fed held rates steady last week as expected, the Committee notably stated its focus on both its maximum employment and price stability mandate, a departure from previous statements which focused primarily on inflation risks. There were a few adjustments in terms of the description of the labor market in which the Committee had noted that job gains have moderated, and that the unemployment rate has moved up recently, but remains low. Chairman Jerome Powell also highlighted the broadness of recent disinflation, which permits the Fed to be slightly less focused on inflation and more attentive to growth and labor market risks. The incoming data regarding the labor market will be key in guiding the Fed’s reaction function in the coming months.

Turning to the data, the July jobs report delivered a material disappointment. Taking a step back, the unemployment rate has been useful in providing signals on the proximity to a recession. Thus, July’s 0.2% point uptick in unemployment rate to 4.3% triggered the Sahm Rule1, which states that the economy is entering/about to enter a recession when a three-month moving average of the unemployment rate has risen by at least 0.5% point above the minimum 3-month average seen over the prior 12 months (Exhibit 1). While we had expected a modest rise in the unemployment rate and see the labor market as balanced, a look at history demonstrates the possibility that once the unemployment rate starts to rise, it can do so quickly if the economic cycle deteriorates.

At the same time, non-farm payrolls (NFP) rose by 114K, marking the slowest print in over three years with fairly broad-based signs of weakening across the economy as a few services sectors reported declines in payrolls over the month. Other jobs data last week danced to the same tune as labor cost pressures eased last quarter relative to the start of the year when both the employment cost index (ECI) and unit labor costs (ULC) exhibited some strength. Beyond the labor market data, the manufacturing purchasing managers index (PMI) and ISM surveys pointed to softness in the sector. The upshot is that the manufacturing PMI remains comfortably above its cycle low.

However, it is important to recognize that it is not entirely all bad news on the labor front. Labor force grew by 420K, confirming that the economy is still adding workers despite slowing momentum. In other encouraging news, U.S. productivity rebounded in 2Q24, up 2.7% over a year ago.

More recently, softer labor market data has been viewed as a market positive as inflation pressures could diminish through the wage channel. With wages contributing less to the inflation outlook, however, negative news on the labor market might be interpreted as bad news for the economy and raise the prospect of the Fed being behind the curve when it comes to easing policy rates.

Unless we get markedly strong economic data, the series of disappointing data prima facie could accelerate the monetary policy easing cycle. It is no surprise that markets are now pricing in a 50 basis points (bps) cut in September. In response to the recent weakness in the economic data, the Fed is likely to front-load policy easing, with further 50 bps cuts in both November and December, to achieve the neutral interest rate and maintain some degree of flexibility.

Over the last three trading days, TOPIX dropped 20.3%. More notably, the 12% decline on August 5 was the second largest on record, following only that on Black Monday, October 20, 1987. At the time of writing, USD/JPY has fallen close to 9.1% since July 11, when the U.S. released the soft June consumer price index (CPI) print. Carry trades, which arguably have been a key focus, tend to unwind when we witness 1) narrowing interest rate differential and/or 2) increase in FX volatility.

Exhibit 2 illustrates the impact of narrowing interest rate differentials: when interest rate differential narrows, the grey line points downwards, suggesting the difference between 10-year U.S. treasury yield and 10-year Japan government bond yield narrows, thereby leading to a stronger Japanese yen (blue line).

Japanese yen (JPY) shorts peaked for hedge funds when USD/JPY reached 150 (around March this year), but for real money when USD/JPY reached 160 (around June). In June, IMM’s (International monetary market’s) JPY short positions surged i.e. increased JPY selling due to activation of JPY carry trade, which continued amid the possibility that the USD/JPY could aim for 165 JPY as the interest rate gap continued to widen.

The turning point was the release of the U.S. June CPI on July 11 that bolstered the conviction for rate cut expectations by the Fed. Since then, with narrowing interest rate differentials between U.S. and Japan, JPY short positions continued to unwind, impacting overall carry trades globally. Since then, JPY short positions have reduced which contributed to further JPY appreciation.

Meanwhile, Exhibit 3 illustrates the impact of an increase in FX volatility: the implied USD/JPY volatility (grey line) rose due to ongoing geopolitical uncertainties while the investors became risk averse. 1-month implied exchange rate volatility rose to 15.6%, much higher than the year-to-date average of 8.9% and 10-year average of 8.6%. As the market continues to digest the incoming U.S. economic data, the carry unwind may continue while USD/JPY will likely continue to be driven by the outlook for U.S. monetary policy. We also remain cautious about volatility due to uncertainty around political events in Japan and the U.S.

Having said that, Japan’s corporate governance improvements remain a key factor supporting the long-term investment case for Japanese equities. Furthermore, companies could unwind cross-holdings in equities to free up capital and engage in more share buybacks. Meanwhile, further improvement in the macro environment, which we expect in 2H24, will be a key catalyst for sustained Japanese share price gains. At the same time, a stronger JPY may attract international investors who have been put off by the JPY weakness given the hedging costs.

The baseline scenario around U.S. growth remains one characterized by a slowdown rather than a recession. Investors should remain watchful over incoming U.S. labor market data and ensure portfolios are well-diversified to weather the possibility of a greater slowdown. There are a couple of investment implications. Firstly, there is opportunity for investors to add to equities at better valuations in a market that has tended to over extrapolate the weakness in the economy, especially in the event that the data improves. In particular, the focus on quality when it comes to risky assets such as equities should be on the top of the mind for investors. Secondly, in the event of a sharper growth contraction that is met with deeper policy rate cuts by the Fed, investors could extend duration into high-quality bonds which could provide stable returns in the long-term. Thirdly, the imminent monetary policy easing by the Fed could imply the weakening in the U.S. dollar, implying stronger return on non-U.S. stocks. Thus, investors’ portfolios should be allocated across both U.S. and global equities.

The Federal Reserve may be a bit late cutting interest rates, but it's not yet behind the curve in forestalling a U.S. recession.

For all the wild financial swings and furious trading of the past week, markets have yet to price in a Fed monetary policy stance that would actively stimulate the economy at any point over the coming two-year cycle.

While that could highlight investors' lingering concerns about sticky inflation, it more likely reflects their doubts that some deep recession is in fact brewing.

And what it indicates most clearly is that the Fed only has to lift its foot off the brake to keep the expansionary ride going.

Markets were clearly spooked by the surprisingly sharp rise in the U.S. jobless rate last month - and further aggravated by the Big Tech stock shakeout. As volatility spiked, markets have raced to price a series of deep Fed rate cuts over the months ahead.

Just one month ago, futures prices indicated that barely two quarter-point cuts were anticipated over the remainder of the year, but now they show expectations of twice that - some 115 basis points at last count on Tuesday.

Most notable among a series of hastily revised forecasts, U.S. investment bank JPMorgan now projects that we will see two half-point cuts in both September and November, followed by a quarter-point cut in December.

Not for the first time, this may seem a little overcaffienated. And it certainly reflects the market volatility present right now in a holiday-thinned August.

But what's happened further out the curve is perhaps more instructive about what investors expect to see in the full easing cycle ahead.

There's little doubt now the Fed will start cutting next month: its signalling about that was crystal clear at last week's meeting. But where the cutting stops is less obvious.

Looking at futures and money market pricing on Monday, the so-called terminal rate over the next 18 months never got below 2.85%, even during the most extreme part of the day's turbulence

That's a long way down from the current policy mid-rate of 5.38%.

But it's still above where Fed policymakers see the long-term 'neutral' rate - widely seen as their proxy for the fabled 'R*' rate that neither stimulates or reins in economic activity. That median long-run rate is currently 2.8% - after being pushed up 30 basis points by Fed officials this year.

So, if anxious money markets don't think the Fed will be forced to go below that, then the slowdown ahead can't be expected to be that bad - despite all the hand wringing of recent days.

At the very least, it suggests markets remain equivocal about recession and think the removal of policy 'restriction' may be enough by itself to hold the line.

Another way to look at it is to view the 'real' inflation-adjusted Fed policy rate, which is currently 2.5%. That's the highest level in 17 years. It has risen steadily from zero since April 2023 as disinflation has set in.

If the Fed's full easing cycle turned out to be the 250 bps suggested by markets this week - and consumer price inflation were to remain as high as 3% through that period - then the real policy rate would merely return to zero at its lowest.

Bear in mind that the average real policy rate over the past 15 years was -1.4%, so a reversion to zero is not suggesting the Fed is heading for anything like emergency mode.

All conjecture? The Fed has a busy six weeks ahead to clear it all up.

Fed officials speaking this week suggest they're not too worried about recession yet but everything is still on the table policy-wise. They also insist that they will continue to have meeting-by-meeting assessments and that one month of data or market upheaval won't change their minds unduly.

Perhaps cryptically, San Francisco Fed chief Mary Daly said the central bank "is prepared to do what the economy needs when we are clear what that is."

Part of what set recession talk rumbling was the triggering last week of the so-called Sahm Rule, which posits that a 0.5 percentage point rise of the three-month average jobless rate over the low of the prior year typically presages recession.

But even the rule's author, ex-Fed economist Claudia Sahm, downplayed the latest trigger due to pandemic and weather- related distortions still plaguing the jobs data.

And yet, with the labor market softening either way, the Fed still seems set for a September rate cut - a move that will also be accompanied by an update of policymakers projections, including that long-run neutral rate.

And before then, the Kansas City Fed's annual Jackson Hole symposium takes place on Aug. 22-24 - where longer-term Fed thinking tends to get sketched out in more detail.

"It was a mistake that the Fed didn't cut rates last week, but I don't believe it will cause irreparable damage to the economy," reckoned Invesco strategist Kristina Cooper. "This sell-off (in stocks) is a very emotional market reaction that is overestimating the potential for recession."

And the rates market may not even be pricing in recession at all.

When significant geopolitical news breaks, markets often react with a movement of panic. Investors look to shelter in assets considered safe. This can cause a drop in cryptocurrency prices.

However, cryptocurrencies, often seen as an alternative store of value, could also see an increase in demand. This dual dynamic can lead to increased volatility, with sudden and unpredictable price fluctuations.

During times of crisis, trading volumes on cryptocurrency exchanges tend to increase. Investors attempt to quickly reposition themselves, whether to secure their investments or to capitalize on market opportunities.

An Iranian retaliation accompanied by threats of cyberattacks or other forms of destabilization could amplify these movements. This volatility could be exacerbated by massive sales of leveraged positions, as observed during previous crises.

Liquidity is crucial in times of turbulence. Investors seek to convert their assets into cash quickly, which can cause price drops even for assets deemed solid.

Cryptocurrencies, with their decentralized nature, offer some flexibility but can also be subject to liquidity shortages. Centralized and decentralized exchanges will therefore have to manage sudden influxes of transactions, with potential risks of congestion or failures.

Bitcoin, often dubbed "digital gold", could see its demand increase as a safe-haven asset.

During times of crisis, investors seek assets not correlated to traditional markets.

Bitcoin, with its decentralized nature and resistance to censorship, could be seen as a safe alternative. However, this perception depends on investors’ confidence in the resilience of crypto infrastructure against potential threats.

Short-term traders might see the increased volatility as a profit opportunity. Price fluctuations offer quick gain possibilities but also increase the risk.

Trading strategies such as scalping or day trading might become more popular. However, these strategies require rigorous risk management, as market movements can be abrupt and unpredictable.

In a context of geopolitical tensions, caution is necessary. Institutional investors might reduce their exposure to cryptocurrencies while awaiting stabilization.

Similarly, retail investors will feel the urge to diversify their portfolios to minimize risks. Long-term investment strategies might include allocations to less volatile assets, such as stablecoins, or investments in resilient decentralized infrastructures.

An Iranian retaliation could include cyberattacks targeting critical infrastructures, including those of cryptocurrencies. Exchanges and digital wallets could be vulnerable, increasing the risks for investors.

However, such a situation could also accelerate the development and adoption of more robust security solutions, thereby strengthening the ecosystem in the long term.

Global regulators might react to geopolitical developments by tightening controls on cryptocurrency transactions, particularly to prevent their use in illegal activities or to circumvent sanctions.

This regulatory pressure could limit certain activities but also encourage wider and more secure adoption of cryptocurrencies, incorporating enhanced compliance practices.

Despite short-term challenges, interest in cryptocurrencies could grow, especially in regions where traditional financial systems are under pressure. Iran, for example, could intensify its adoption of cryptocurrencies to circumvent international sanctions, a movement that could be observed in other countries facing economic restrictions. This trend could reinforce the role of cryptocurrencies as viable alternatives to traditional financial systems.

At 9:30 a.m. on August 7, BOJ Deputy Governor Uchida Shinichi held a press conference, and his main points are as follows:

Japan's economy is recovering moderately, although some areas remain weak. In retrospect, the economy continued to grow at a high rate in the first half of 2023, reflecting the normalization of economic activity after the COVID-19 pandemic. The growth rate then turned temporarily negative, partly due to the shutdown of production by some car manufacturers, but the improving trend has continued. The economy is expected to keep growing at a rate above potential.

It is likely that labor shortages will persist, leading to a rise in wages. As a result of irreversible and structural demographic changes in Japan, the gap between the working-age population and the number of employed persons has since narrowed rapidly and now stands at around 6.5 million. The room for additional labor supply will be further limited.

The CPI growth rate, despite some oscillations, eased slightly. The latest figure for June stands at 2.6 percent. Looking at the breakdown, the contribution of food products and that of other goods have continued to be affected by a pass-through to consumer prices of cost increases led by the past rise in import prices. With these pass-through effects waning, however, the positive contributions of food products and other goods have decreased moderately. While price increases led by the rise in import prices have waned, wage increases have been increasingly reflected in prices.

As for the outlook, the year-on-year rate of increase in the CPI for all items excluding fresh food is likely to be 2.5 percent for fiscal 2024 and thereafter is projected to remain at around 2 percent for fiscal 2025 and 2026.

At the Monetary Policy Meeting (MPM) held last week, the BOJ decided to raise its short-term policy interest rate by 0.15 percentage points, the second year that this rate stayed above 2%. Import prices turn positive on an annual basis, reflecting the depreciation of the JPY. Therefore, the BOJ confirmed that keeping the policy rate at 0.25 percent will be better than leaving it between 0 to 0.1 percent.

Maintaining the easing policy is necessary. If the outlook, the upside and downside risks to the outlook, or the likelihood of realizing the outlook change as a result of these market developments, the path of the policy interest rate will certainly change. Therefore, the Bank of Japan will not raise its policy interest rate when financial and capital markets are unstable.