EUR: Political developments offer respite as data disappoints

Germany’s latest ZEW survey came in weaker than expected on both the current conditions and expectations measures. Sentiment across the wider euro area also deteriorated, with the October expectations reading falling below September’s level. These figures reinforce what recent hard data have already signalled: an economy wrestling with stagflation. Earlier this month, both industrial production and factory orders disappointed, underlining the difficult backdrop.

ECB policymaker François Villeroy added to the dovish mood, noting that the central bank’s next move is more likely to be a cut than a hike. This supports the view that supply-driven inflation shocks, which the ECB has previously highlighted as a concern, are proving less persistent than demand-driven ones. With domestic demand stagnant, the latter has become less pressing.

Despite this soft data, the euro gained 0.3 per cent against the dollar yesterday, driven more by political sentiment than by economic fundamentals. French Prime Minister Sébastien Lecornu, reappointed last Friday, appears to have won the support of the centre-left Socialists by shelving his controversial pension reform plan. The proposal to raise the retirement age from 62 to 64 will now be postponed until after the 2027 presidential election. This political compromise offered markets a moment of relief. The French–German yield spread narrowed, and the CAC 40 clawed back some earlier losses.

The euro’s ability to look past dovish economic news and respond positively to political stabilisation made sense in this context. A fragile but noticeable sentiment-driven rebound was welcome after weeks of pressure.

 

GBP: Bank of England and IMF warn on growth outlook

Sterling lost ground yesterday following the release of soft labour market data, which encouraged investors to price in more easing by the Bank of England. Markets now expect around 7 basis points of cuts by December, rising to roughly 8.5 basis points later, though these expectations were partially tempered by persistent inflation pressures.

Comments from policymakers reinforced the dovish tone. MPC member Taylor, a consistent advocate for lower rates, argued that further cuts are needed and warned that weak domestic demand could deepen the downturn. He highlighted the risk of a hard landing, echoing the IMF’s new forecasts. The Fund expects the UK to face the highest inflation in the G7 next year, coupled with the weakest growth in living standards. GDP per capita is projected to lag behind other G7 economies.

Speaking at the Institute of International Finance in Washington, Governor Bailey added a cautious note. He pointed to signs of a softening labour market and expressed less concern about inflation pressures, suggesting that weakening economic activity could weigh on growth in the period ahead. He offered little guidance on the future path of interest rates.

GBP/USD found support at 1.3250 following a small decline of 0.1 per cent, helped by developments in the United States overnight. Signals that the Federal Reserve may be leaning towards further cuts, combined with Powell’s renewed concern about the labour market and the latest trade tensions between the US and China, lifted the pair. Repeated tests of the 1.3250 support area have encouraged buyers to step back in, particularly as hopes for a more decisive hawkish push from some policymakers faded.

 

USD: Inflation story extends beyond tariffs

The delayed release of the September CPI report, now scheduled for 24 October, remains the most significant event on the US economic calendar this month. In the meantime, a limited flow of pre-shutdown data and private sector surveys continues to depict a familiar picture: a cooling labour market alongside resilient consumer spending. This environment supports expectations of another 25 basis point rate cut at the Federal Reserve’s late October meeting. In a speech yesterday, Chair Jerome Powell reinforced this view, pointing to slower hiring and warning that further declines in job openings could eventually push unemployment higher. His remarks capped recent dollar strength, although the index remains above 99 and is up 1.5 per cent so far this month. Persistent trade tensions with China have added to market caution, pushing the VIX volatility index back above 20.

Beneath the surface, inflation dynamics are evolving in a way that complicates the Fed’s response. Tariff-related price pressures, once a minor factor, are now contributing more visibly to headline inflation, particularly in core goods. August data showed a 0.23 percentage point boost from tariffs, marking a shift from deflationary to inflationary pressures in this segment. Categories such as household furnishings and recreational goods are showing the most notable increases, while apparel and vehicles remain relatively subdued. The transmission of trade policy to consumer prices is uneven but significant.

More importantly, inflation is now increasingly driven by domestic demand, particularly in core services excluding housing, which make up over half of the PCE basket. The San Francisco Fed has noted that recent price increases in this area are demand-led rather than supply-constrained. Both core goods and non-housing core services are contributing around 0.3 percentage points above the level consistent with the Fed’s target, indicating broad-based and persistent pressures.

The Dallas Fed has stressed that while tariff effects may eventually fade, there is little evidence of slowing inflation in non-housing core services. The latest FOMC minutes reflect this view. Only a few policymakers attributed high inflation solely to trade policy, while several emphasised that underlying inflation has stalled even when tariff effects are excluded. This stickiness is most evident in services, where price increases are closely tied to domestic labour costs and shelter. Strong wage growth, stemming from a still-tight labour market, continues to feed through into business costs and consumer prices. This feedback loop cannot be resolved through trade policy adjustments alone. Addressing it will require clear evidence of labour market slack.

The Fed’s cautious, data-dependent approach reflects these complexities. Officials are watching indicators such as the unemployment rate, job vacancies, wage growth and the quits rate to judge whether inflationary pressures are starting to ease in a sustainable way.