A Shift in Inflation Risk Perception: US Policymakers May Have Jumped the Gun
US policymakers appear to have gotten ahead of themselves in their lenient assessment of inflation risks. Since prices began rising in early 2021, the Federal Open Market Committee (FOMC) has largely aligned its risk perception with its preferred inflation gauge, the core PCE index. However, starting in 2022, policymakers adopted an even more cautious stance than inflation trends warranted. This dynamic changed in September, when only three FOMC members perceived upside risks to core PCE. We anticipate this assessment will shift upward as the Federal Reserve prepares to pause its easing cycle in January.
Euro Struggles Amid Economic Divergence, but Seasonal Recovery Possible
The euro is facing pressure near the $1.05 level against the USD at the start of the week, despite flash PMI data underscoring the significant divergence between European and US economic activity. The December flash PMIs for Europe point to persistent economic weakness, with the continent stagnating in the fourth quarter.
While the composite PMI remains below the 50 threshold, signalling no expansion, it has recovered much of November's decline. This improvement stems from a notable rebound in the headline services index, which climbed 1.9 points to 51.4. Geographically, France continues to lag, particularly with a dismal manufacturing survey, though its services PMI showed some resilience. In Germany, better-than-expected services PMI results boosted the nation’s composite PMI. Despite this, the broader narrative remains unchanged: the European Central Bank (ECB) is likely to cut rates more deeply and aggressively than the Federal Reserve in 2025, keeping both nominal and real interest rate differentials tilted in favour of the dollar.
Although the euro is down 0.75% this month, seemingly defying typical seasonal patterns, history suggests the common currency often strengthens during the final two weeks of December. A modest euro recovery over the festive period is still possible. However, Q1 2025 is likely to present challenges due to monetary policy divergence, political headwinds in Germany and France, and the looming risk of severe trade tariffs if Trump is inaugurated.
UK Data Sparks Sterling Gains as Wage Growth Surprises
A wave of UK economic data has already hit this week, with the composite PMI holding steady, supported by the services sector. Notably, there was a slight downtick in employment and an uptick in prices. The unemployment rate matched expectations at 4.3%, but wage data came in hotter than anticipated. This has led to modest sterling appreciation across FX markets, with GBP/USD and GBP/EUR approaching $1.27 and €1.21, both gaining nearly a cent since yesterday.
Private sector business activity continues to show slight expansion, marking the 14th consecutive month of growth. Strength in services offset another contraction in manufacturing. However, beneath the surface, there are signs of concern. UK private-sector firms cut jobs at the fastest pace since the global financial crisis (excluding the pandemic), likely reflecting concerns over employment costs as the new budget raised payroll taxes. New orders also fell for the first time in 13 months, casting doubts on future spending trends. Rising wages further pushed average prices charged to their fastest increase in nine months, raising fresh concerns for Bank of England (BoE) policymakers ahead of their final policy meeting of 2024 this Thursday.
This morning’s labour market data highlighted wages as the key driver lifting the pound. Regular wage growth accelerated more than expected in the three months through October, with private-sector regular pay growth—a measure closely watched by the BoE—rising to 5.4% from 4.9%. As a result, money markets have scaled back expectations for UK interest rate cuts in 2025, trimming roughly 10 basis points to price in a total of 62 basis points of cuts, or fewer than three 25bps reductions.