Inflation cools down more than expected, manufacturing output hits near four and a half year high, European Central Bank pauses interest rate hikes with strong data support.

Eurozone economy in June presented a complex signal: on one hand, inflation slowed down more than expected, providing space for the European Central Bank to pause interest rate hikes; on the other hand, manufacturing output achieved its best quarterly performance in almost four and a half years, showing resilience in the real economy. And behind all of this, there is a close connection to the dramatic changes in the geopolitical situation in the Middle East. Comprehensive cooling of inflation, with both core and service prices slowing down Data released by Eurostat on Wednesday showed that in June, the overall Consumer Price Index (CPI) for the Eurozone saw a significant slowdown in year-on-year growth from 3.2% in the previous month to 2.8%, well below the market's expectation of 3.0%. This is a notable drop in inflation rates after the shock of the energy crisis. After excluding volatile food and energy prices, the core inflation rate also surprised the market by dropping from 2.6% in May to 2.4%. More importantly, the service sector inflation rate, which the European Central Bank views as a gauge of domestic price pressure, also dropped significantly from 3.5% to 3.2%. Looking at individual countries, the three largest economies in the Eurozone all recorded slower-than-expected price increases, with France's inflation rate even dropping temporarily to the ECB's target level of 2%. The slowdown in food, energy, and service prices is mainly attributed to the market's increasing optimism on the Middle East peace process. News of negotiations between the US and Iran for a ceasefire led to a significant drop in international oil prices, directly reducing energy costs and indirectly easing broader price pressures. Resilience in manufacturing, with record output for the quarter At the same time, a survey released by S&P Global on Wednesday showed encouraging resilience in Eurozone manufacturing amidst weak demand. The Eurozone Manufacturing Purchasing Managers' Index (PMI) for June dropped slightly from 51.6 in May to 51.4, reaching its lowest point in four months but still staying above the 50 neutral level for the fifth consecutive month, slightly better than the preliminary value of 51.3. More encouragingly, the output component's performance was strong. The manufacturing output sub-index increased from 51.3 to a two-month high of 51.7, marking a strong end to the entire second quarter. Chris Williamson, Chief Business Economist at S&P Global Market Intelligence, stated that the expansion in June marked the "strongest quarter for Eurozone manufacturing output since early 2022," partially offsetting recent downward pressure in the service sector and demonstrating resilience in the Eurozone economy. Demand also saw a modest improvement. New orders, which were flat in May, showed a slight increase in June, although export orders remained a slight drag, indicating continued weakness in external demand. Among the Eurozone countries covered in the survey, only Spain and France reported output declines. Cost pressures eased, supply chain tensions temporarily alleviated The impact of the geopolitical easing is gradually filtering into the supply chain. Data shows that the manufacturing supplier delivery time sub-index has reached a three-month high, indicating some easing in supply disruptions caused by conflicts. To cope with previous uncertainties, manufacturers had consumed a large amount of precautionary inventories, leading to a significant reduction in pre-production inventories. In terms of prices, input cost inflation, although still high, has slowed to its lowest pace since March, ending a continuous acceleration trend since September last year. Output price inflation has also dropped to a three-month low. The report pointed out that the easing of cost pressures "largely reflects the sharp fall in oil prices during the month and the easing of supply concerns." However, S&P Global specifically noted that most of the survey responses were collected before the US and Iran signed the ceasefire memorandum on June 17, so the data did not fully reflect the potential positive impact of this event. Williamson warned that the positive changes in the Middle East situation may not necessarily sustained improvement in manufacturing performance. On one hand, falling energy prices and supply improvements can directly lower business costs and boost consumer demand by curbing inflation; but on the other hand, the preventative inventory effect from the past few months that benefited manufacturers is weakening and may instead become a drag on growth in the future. Other survey data shows that although manufacturing employment continued to decline, the rate of job cuts had slowed down, reflecting caution from companies in adjusting manpower when demand outlook remains uncertain. Business confidence improved for the second consecutive month. The confidence index for June reached a four-month high, continuing the rebound from a 17-month low in April, but still slightly below the long-term historical average. European Central Bank enters a patient window, but tightening is not over The dual data of inflation and the real economy have temporarily shifted the balance for the European Central Bank towards a wait-and-see approach. Due to the energy price shock, the ECB announced in June a 25 basis point increase in deposit rates, marking its first rate hike since 2023 to contain inflation that had once exceeded 3% and far surpassed the target rate. However, the moderation in price pressures at present significantly enhances the reasoning for policy makers to postpone further actions. Several central bank officials have stated publicly or in private that there is no need to rush to raise rates again in July after doing so in June; they can afford to spend some time observing how price pressures evolve. The ECB in particular is concerned about the initial energy shock spreading to other goods and services prices, ultimately pushing up wages. However, such "second-round effects" have not materialized yet, and wage pressures have not accelerated. At the ECB's annual forum, Bundesbank President Joachim Nagel stated that while the unexpected drop in oil prices was positive, the development of the fragile situation in the Middle East still needs to be observed, keeping options open for the meetings in July and September. Chief economist Philip Lane emphasized the need to examine how the recent rise in energy costs would "feed into food inflation and service sector inflation." Currently, the market generally expects the ECB to pause at its next interest rate meeting on July 23, but most economists and investors still anticipate another rate hike in September or October. Market pricing indicates that by the end of the year, the ECB may raise rates by another 25 basis points, bringing the deposit rate to 2.5%. However, with the cooling of the energy market reducing the extreme policy scenarios, bets on a more aggressive tightening path have started to converge. Looking ahead, risks have not completely dissipated. Energy prices are still higher than pre-war levels, and conflicts in the Middle East have seen unexpected turns multiple times, keeping price expectations volatile. Additionally, fertilizer shortages in the Middle East and the possibility of heatwaves in Europe could reduce crop yields, potentially adding upward pressure on food prices once again as energy costs fall.