Economy in Brief

The ZEW financial experts in September see broadly improving macroeconomic conditions in the euro area, Germany, the United States, and China. There are step-ups in each of these areas, mostly by modest increases of four to seven points month-to-month. However, Germany shows a month-to-month increase of 14 points, the largest gain of the group. The percentile standings of the readings show an above-median (which means an above 50th percentile reading) for the euro area at a 59.8 percentile and for China at a 77.3 percentile. Both Germany and the U.S. lag their medians, with Germany at a 38.9 percentile standing and the U.S. at a 44.5 percentile standing.

Economic expectations are little changed and mixed among the three countries: Germany, the U.S., and China. The U.S. sees a slight setback as its monthly reading falls by 3.2 points; German expectations edge up by 0.5; China’s reading falls by 4.1 points. Only the reading for Germany stands above its 50th percentile, at the 59th percentile standing.

Inflation expectations are probably the big story this month, with big changes in all the reporting units of over 20 points on the month and all of them jumping up well over their median estimates, with rankings ranging from a 52.3 percentile standing in the U.S. to an 81.8 percentile standing in China. The outlook for inflation has suddenly worsened largely on events in the Middle East, rising oil prices, and increased pessimism about prospects for peace in the Middle East anytime soon.

Because of this short-term interest rate expectations are also higher, rising by 39 points in the U.S., 19 points in the euro area, and over 13 points in China month-to-month. All the readings for short-term rate expectations are above their medians, well above their respective 50th percentiles, with standings ranging from a low of the 71st percentile for the U.S. to the mid-80th percentile for both the euro area and China.

There are smaller increases, although increases in each of the areas, for long-term interest rate expectations, with the largest increases for the U.S. at 11.5 points on the month, whereas Germany and China log increases of about 3.8 to 3.9 points. Percentile standings show that long-term rate expectations are only above the 50th percentile standing for China, whereas for Germany they are at the 37th percentile. For the U.S., they are at the 44th percentile. Though the sharp increase in inflation expectations seems to have caught short-term interest rates off guard, longer-term interest rates have followed suit with only relatively small adjustments, not jumping to draconian levels, at least not yet. This would suggest that, with the rise in short-term expectations, financial experts think that central banks are still in control of inflation developments. That’s good news.

Not surprisingly, against this background stock market expectations deteriorated in each region. The smallest decline was in Germany, a decline of 4.4 points, while the largest was in China, a decline of 11.8 points. Germany is the only area where the stock assessments are below their 50th percentile. The euro area just makes the 50th percentile mark at 50.5. The U.S. comes in at a 58.3 percentile, while China has a 62.1 percentile standing assessment for the month. Generally speaking, the acceleration of inflation expectations has created some setback on stocks but hasn't had a draconian impact there either.

The outlook is that the economic situation has improved slightly in the month and economic expectations have a mixed performance and are generally slightly subpar. Inflation expectations jump sharply and have had a big impact on short-term rates, a more moderate impact on long-term rates, and a modest impact on stock values. Because of the sharp one-month rise in inflation expectations, we're going to want to watch these developments very closely.

Japan’s industrial production rose in July largely on a jump in gas & electric utilities output. But manufacturing IP made a small move backward, with output falling by 0.1% month-to-month. Consumer goods output did turn sharply lower in July, dropping by 1.3% month-to-month, but intermediate goods output advanced by 0.2% as capital goods output continued to gear up, rising 3.2% month-to-month after rising 5.5% month-to-month in June. These gains in capital goods output followed a 3.1% drop in May.

Overall industrial output sequential gains show an accelerating output trend. The 12-month gain is 3.6%, the six-month annualized gain is nearly identical at 3.5%, and the three-month annualized gain is at a hefty 9.7%.

Sequential trends in manufacturing show more fluctuations and less of an arrow-straight trend. For manufacturing, 12-month growth is 4%, while three-month annualized growth is 8%. There is a lull in between, with six-month growth showing a 0.2% annual rate decline. Manufacturing sectors generally show a similar pattern, with solid 12-month growth, weaker growth over six months, and a pick-up over three months, with the three-month pace rebounding and turning sharply stronger than its 12-month pace. We see that for intermediate goods and capital goods, with only consumer goods showing steady output deterioration from 12 months to six months to three months. Yet, as the graphic shows, retail sales are holding up and tracking with industrial output gains overall.

On a quarter-to-date basis, very early in Q3, output is rising at a 12.3% annualized rate over its Q2 level. Manufacturing output is up at a 7.6% pace. Consumer goods output is a drag, with output falling at a 5.1% annual rate, offset by a 5.4% gain in intermediate goods and capital goods output exploding at a 40.1% annual gain. Utilities & mining output also are rising clearly and strongly in the quarter.

However, Japan’s economy is still in recovery mode. As the table clearly shows, all IP measures are lower than they were one year ago. The economy is still digging out after retrenchment. Moreover, output is still broadly weaker than it was in January 2020 before COVID struck. That’s a long time for output to not have risen, 6½ years. On that comparison, only investment goods output and electric & gas utilities output are higher in July of this year than in January 2020, and in both cases it is by less than 2%.

In this week's Letter, we examine the divergences running through Asia's inflation, monetary policy and currency performance. Headline CPI inflation has risen across much of the region, driven in large part by the closure of the Strait of Hormuz. Underlying dynamics nonetheless remain disparate, with China recording the region's lowest inflation rates and India facing renewed food and oil pressures (chart 1). China warrants closer attention still, since its producer price inflation now runs far ahead of consumer inflation (chart 2). Weak passthrough to domestic prices, soft demand and Beijing's campaign against destructive price competition all help explain that gap. Disparate inflation outcomes, in turn, are feeding divergent monetary policy stances, though that divergence has narrowed somewhat (chart 3). India has paused its rate cuts, while the Bank of Japan continues its gradual normalisation. Japan also sits at the centre of a protracted rise in yields, shared with its major-economy peers. A decomposition suggests real yields, rather than breakevens, have been the greater driver, amid concerns about fiscal policy and capex (chart 4). Divergence runs through currency performance too, with relative standings shifting repeatedly on a trade-weighted basis (chart 5). The Indian rupee has been the worst performer year-to-date, only recently ceding that position to the Philippine peso. At the other end of the table, the Chinese yuan has been dethroned by a resurgent South Korean won. Strong AI-driven export inflows had long been offset there by persistent portfolio outflows.

Inflation divergence Headline CPI inflation has risen across much of Asia this year, on many measures. Surging energy prices, driven by the continued closure of the Strait of Hormuz, account for a large part of that rise. Underlying inflation dynamics within the region, however, remain quite disparate from one economy to the next. External forces such as oil prices and supply shocks are only part of the story. Domestic conditions matter too, notably the strength of domestic demand and each economy's dependence on imported goods, which is another way of describing its degree of self-sufficiency. China illustrates the point, with inflation still short of breaking conclusively above the low to no inflation region. That owes arguably in part to domestic demand conditions, which remain comparatively weak. It has once again logged the region's lowest inflation rates in recent months, reclaiming that spot from Thailand (chart 1). India sits at the other end, having ceded the top spot for headline CPI inflation to the likes of Vietnam and the Philippines since early 2025. Its recent resurgence in consumer inflation nonetheless points to a dependence on imported oil. Fresh risks have also emerged more recently from food and agricultural shocks, tied to ongoing and possibly worsening El Niño effects.

One thing is clear: it is not a deflationary world Japan's PPI headline cooled in August, rising by only 0.1%. However, the headline for the all-manufacturing PPI rose by 0.3%, indicating more pressure.

Sequential inflation pressures for Japan’s overall PPI show a 7.6% gain over 12 months, accelerating to 12.7% at an annual rate over six months, and calming to a still-hot 4.5% over three months. For all-manufacturing, the 12-month gain is 7.7%, the six-month pace annualized is 12.4%, and the three-month pace annualized is 4.6%. These sequential results are very similar for these two series. Despite a substantial deceleration in place from 12 months to three months, the three-month pace is still hot, and the pace of the last two months is still at a troublesome 5% to 5.5%.

Japanese PPI data are available ahead of the CPI data. In the shaded columns of the table, we can compare PPI trends in the EMU and the U.S. through July, as well as Japan's own CPI trends.

These lagged comparisons show that PPI inflation in the European Monetary Union, while excessive over 12 months and six months, somewhat like Japan, has shown a sharper deceleration over three months. In the U.S., finished goods PPI inflation shows somewhat more tempered overall performance compared to Japan, but the just-released August data have turned hot again. The global PPI picture is not reassuring.

However, Japan's CPI, which is the more important reading for central bank attention, shows inflation at 2% over 12 months, rising to a 3% pace over six months and to a 4.4% annualized rate over three months. Japan’s core inflation similarly registers as an expansion of about 1.5% over six months and 12 months but logs a 2.8% increase over three months. Inflation remains restless.

Brent oil prices declined in August, but in spot markets oil is back over $100 a barrel, so it's not clear that we should view August, or the three-month trends, as good news. The Strait of Hormuz continues to be adversely affected. While some oil is getting out, clearly not enough is in circulation to calm world oil markets. In addition, there's a lot of concern about what's going to happen to LNG supplies as winter approaches and LNG is used for heating fuels, particularly in Europe.

Quarter-to-date inflation shows hot numbers for Japan's overall PPI and all of manufacturing. Running at a pace of about 6% in the quarter, there's not much that's reassuring despite the fact that there is a step-down of inflation in August. And will the August ‘print’ even be sustained?

The right-hand column shows the correlation between the price measures in the stub of the table at the left and oil prices. Japan's PPI has positive correlations of about 0.4 with Brent; the European Monetary Union has a PPI correlation of about 0.55. In the U.S., the PPI finished goods index has a correlation of about 0.4. However, in Japan, the CPI has a negative correlation of about -0.2 to -0.4.