US CPI offered the first positive surprise on inflation in a long time being flat on the month of July versus consensus expectations of 0.2% m/m. And it was not all due to lower gasoline prices as core inflation also undershot expectations rising 0.3% m/m versus consensus of 0.5% m/m. The good news is that there are clear signs that pressure on goods prices are easing: commodity prices have come down, freight costs are lower, supply chains are easing and pricing power is weaker as demand has softened and inventories are high. We also see tentative signs that inflation expectations have peaked.

However, it is too early to declare victory over US inflation as several Fed speakers also highlighted afterwards. The labour market is still very tight and employment growth has not yet cooled down suggesting that wage growth will continue to run high. It is currently close to 6%, which is much too high to bring inflation back to 2% on a sustained way. Hence, we still look for the Fed to hike 75bp on 21 September to get rates quickly back to neutral and into restrictive area. Admittedly the probability of only 50bp has increased and the decision will most likely be determined by the next round of payrolls and inflation in early September.

In the euro zone the inflation picture has been further complicated over the summer by a strong rise in gas and electricity prices. The warm weather has increased demand for air-conditioning and curtailed electricity production due to droughts that lower water levels in reservoirs and rivers and also led to a reduction in French nuclear power production. For environmental reasons French nuclear plants face restrictions on discharging water into waterways when river temperatures get too high. French electricity prices have doubled over the past three months and are now 10 times higher than in April. The increase is set to push up inflation even further and add to recession risks, thus exacerbating the stagflationary environment.

On the geopolitical front China concluded military exercises around Taiwan in what has been the largest scale drills around Taiwan ever. It comes in response to the visit by US speaker of the House Nancy Pelosi, which in China’s view is a breach of the ‘One-China policy’ and a further move towards supporting Taiwan independence. This week we sent out a paper looking into the background of the crisis and assessing the risk of war, see Research China: The risk of a Taiwan war and what it implies – part 1, 11 August.

Markets mainly responded to the lower-than-expected US inflation print this week by sending equities and EUR/USD higher. Bond yields initially dropped following the release but moved higher again Thursday as optimism about lower inflation and slower rate hikes faded again.

Looking into next week the main releases will be US data on retail sales, regional business surveys for August and housing data. In Europe we get the German ZEW and the final CPI print for August, which provides more details than the flash estimate. China will publish it monthly batch of industrial production, retail sales and home sales. Especially the latter will be interesting given the continued stress in the property market. Norges Bank is set to increase rates by 50bp on Thursday.

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