ECB to raise interest rates by 75bps
The main event of the week is the ECB’s policy announcement on Thursday. After last week’s flash euro area HICP estimates in August surprised on the upside – with the headline rate up to 9.1%Y/Y and the core measure up to 4.3%Y/Y – the ECB will have to revise up significantly the profile of its inflation projection. Indeed, the average headline rate in the first two months of Q3 was 9.0%Y/Y, a hefty 1.7ppts above the ECB’s baseline forecast for the quarter published in June. There is now a good chance that inflation will reach double-digits in Q4. And with European natural gas prices having rebounded sharply this morning after Gazprom decided not to switch the Nord Stream 1 pipeline back on after three days of maintenance, and the euro down below $0.99, risks to the inflation outlook are clearly skewed even further to the upside.

Of course, that also increases further the likelihood of a euro area recession over coming quarters. But the ECB’s mandate means that it has to prioritise the battle against inflation. So, the Governing Council will judge that it will be a job for fiscal policy to cushion the impact of high energy prices on households and firms – and it will also be reassured somewhat by German Chancellor Scholz’s weekend announcement of plans for an extra €65bn of relief measures, funded at least in part by a windfall tax on electricity generators. And with real short-term interest rates still highly negative and a long way from neutral let alone a restrictive stance, another big hike seems in order this week. With the hawks having had a majority on the Governing Council, a hike of 75bps – which has been increasingly priced-in over the past week – now looks odds-on. With another hike of at least 50bps then likely for October, and a neutral stance likely to be achieved by year-end, the Governing Council might also this week request advice from the ECB’s committees – to be discussed at a future policy meeting – on an appropriate strategy for reducing the stock of bonds purchased under the regular APP programme (i.e. quantitative tightening) for if and when it eventually decides to push policy into restrictive territory.

Truss to be confirmed as UK PM with markets (rightly) doubting the wisdom of her policies
At lunchtime today, Liz Truss is set to be confirmed as Boris Johnson’s successor as UK Prime Minister. The opportunistic UK Foreign Secretary, who presented herself as a libertarian throughout her campaign, badly lacks credibility, going some way to explain the kicking received by sterling over the past month. According to a YouGov poll published on the weekend, only 12% of Brits expect her to be a good or great PM, while more than half expect her to be poor or terrible. And markets appear to take a similar view. Certainly, her plans raise significant questions about her commitment to fiscal sustainability. Proposals for a reversal of this year’s increase in National Insurance Contributions and a commitment not to hike the main corporation tax will cost upwards of £30bn, while vague proposals to increase very significantly public spending – purportedly worth somewhere between £50-100bn – to soften the blow of energy price hikes on households and firms will further add to borrowing, making it inevitable that she will suspend the government’s current fiscal rules. Added to similarly vague proposals to review the BoE’s mandate, there’s no surprise that the credibility of the UK’s macro policy framework has been called in to question, pushing sterling lower and Gilt yields higher, and increasing the likelihood that the BoE will need to tighten monetary policy all the more aggressively over coming months. In that context, Governor Bailey, Chief Economist Pill and external MPC members Mann (who is hawkish) and Tenreyro (who was the only member to vote for a hike of just 25bps in August) will appear before the Treasury Select Committee on Wednesday. Expect the impact of weak sterling on the inflation outlook to be one focus.

Economic data:

Japanese surveys point to softer economic momentum, as spending hit by higher prices and rising Covid cases
While today’s final Japanese services PMIs brought a modest upwards revision from the flash, the survey was still consistent with slowing economic momentum over the summer as the number of new Covid infections rose. Indeed, the headline activity index was still down 0.8pt on the month to 49.5 in August, a five-month low, with the new business component (50.0) down for a third consecutive month and consistent with no growth ahead. And this weakness might well be mirrored in Thursday’s economy watchers survey. Certainly, tomorrow’s household spending and BoJ consumption activity numbers might well suggest that consumers were more restrained at the start of Q3 amid historically low confidence, higher prices and declining real incomes. Indeed, while the latest wage figures (also due tomorrow) are expected to report another month of solid growth of almost 2%Y/Y, real wage growth will remain in negative territory for the third consecutive month. Separately, Thursday’s updated national account figures look set to see GDP growth revised notably higher in Q2 on the back of stronger capex growth and a smaller drag from private inventories – our colleagues in Tokyo are forecast an upwards revision of 0.5ppt to 1.0%Q/Q.

Euro area retail sales expected to have risen at start of Q3, despite softer sentiment, higher prices and falling real incomes; German factory orders and IP due later in the week
Euro area retail sales for July are due to be published today. Despite the mixed results from national spending figures, with German retail sales having posted a solid increase, we expect euro area retail sales to post modest growth of about ½%M/M, albeit insufficient to reverse the drop of 1.2%M/M in June. The latest sentiment surveys – including the final August services PMI and the Sentix investor confidence survey for September will likely add to evidence that the euro area economy is heading for recession. In the meantime, however, final Q2 euro area GDP figures (Wednesday) should confirm growth of 0.6%Q/Q, driven by a rebound in consumer spending on services as pandemic restrictions were eased. At the member state level, the flow of July data will include German factory orders (tomorrow), as well as German and French industrial production (Wednesday and Friday respectively).

UK dataflow to be dominated by surveys, with the final services PMIs for August due today
A relatively quiet week for top-tier UK releases brings various sentiment surveys, including the final August services and composite PMIs (today), construction PMIs and BRC retail sales monitor (tomorrow), followed by the KPMG/REC report on jobs and RICS residential survey (Thursday) and the Bank of England’s latest inflation attitudes survey (Friday). While the flash services activity PMI (52.5) held up relatively well, it still recorded the softest reading since February 2021. And the composite PMI will remain consistent with a marked slowing in economic momentum over the summer. The BoE’s survey seems highly likely to report a further rise in expectations for the coming twelve months from the series high of 4.6% registered three months ago.

US services ISM expected to point to softer economic growth; Powell in action on Thursday
When US markets reopen after today’s national holiday, the week’s data calendar kicks off with the services ISM for August, which is expected to signal a further slowing in economic momentum during the summer, albeit remaining comfortably in expansionary territory. Our colleagues in Daiwa America expect the headline activity index to drop 1.7pts to 55.0, in line with the consensus, although the activity and new orders components are subject to downside risks given the surprising strength in July. Wednesday will bring the full trade report for July. The advance goods trade figures reported a narrowing of $9.5bn in the trade deficit in July, due to a drop of 3.5%M/M in imports that outpaced a more modest decline in exports (-0.2%M/M). The surplus in services trade has moved erratically in recent months, but it has drifted upward since mid-2021 and could make a small positive contribution in July. In terms of Fed speak, most notably, Chair Powell will participate in a conference on monetary policy on Thursday.