US, Europe maintain cautious optimism as Japan faces hawkish outlook

Both the US and European economies are practicing “cautious optimism” given favourable conditions for monetary policy easing at the same time as Japan faces a prolonged period of tightening, according to new commentary from Franklin Templeton’s fixed income experts.

The fund manager’s fixed income team, including Chief Investment Officer Sonal Desai and Economists, Angelo Formiggini and Rini Sen, said financial conditions in the US have returned to mid-2020 levels and European growth is set to be supported by increased fiscal spending in Germany, while Japan is challenged by sticky food inflation and a contraction in real wages.

“[In the US], inflation data, while stable, shows signs of persistence in non-housing services and input prices, indicating that the case for easing rests squarely on the perceived risks to employment,” the commentary said.

“Despite the slowdown in labor demand, wage growth has remained above 4% for the past year. Interestingly, wage growth has eased for lower-income groups, implying that tighter immigration has yet to translate into higher wages for low-skilled workers.

“July spending data confirmed that the “payback” from tariff front-running abated as spending rebounded, especially in durable goods, supported by real income gains. This is significant because, like goods-sector employment, durable goods are typically the first category to show signs of cooling. However, tariff-inflation and reduced transfer payments may soon pressure lower- and middle-income households. Corporate profits remain resilient, but margin pressures are rising due to significant tariff-related costs.

“Many firms are reportedly renegotiating supplier terms, restructuring supply chains, and/or passing increased costs on to customers. Meanwhile, corporate concerns over wage pressure have eased and the probability of layoffs remains limited. Regional Fed surveys show a gradual recovery in firm capital expenditure (capex) intentions, corroborated by rising new orders and imports for capital goods. A sharp upward revision to intellectual property investment in the second estimate of the second quarter GDP likely reflects a lift from enterprise spending on generative AI products, suggesting that firms are actively investing in productivity enhancing measures.

“Cautious optimism characterises our medium-term outlook for the euro-area (EA), due to the expected impact of Germany’s fiscal stimulus, which the market appears to be under-appreciating. Germany’s draft budget in June announced sizeable fiscal spending (amounting to approximately 20% of 2024 GDP) over the next four years, with significant front-loading expected. However, headwinds persist in the near term.

“The overall growth trend across the euro-area remains sluggish, with inventory building largely driving second-quarter growth [0.1% quarter/quarter (q/q) and 1.4% year/year (y/y), with growth]. Although exports were a negative contributor (-0.5% q/q), the payback from the front-loading of trade in the first quarter was lower than expected. More striking was the slowing in private consumption and in investments in the largest four EA economies (Germany, France, Italy and Spain), attributed to uncertainty and low confidence amid trade-related uncertainty.

“Modest business optimism versus timid consumers: Nonetheless, leading indicators, such as business surveys, have shown improvement. The composite Purchasing Managers’ Index of manufacturing rose to a 3.5-year high in August. This trend is also being reflected in a clear improvement of the expectations component of the German Ifo index, driven by an expected positive impact from fiscal stimulus.

“In contrast, consumer confidence surveys remain weak, despite a modest pickup during the first quarter that has since flatlined. Consumers remain reluctant to spend, with savings still above pre-COVID-19 levels. As confidence returns, a high savings rate coupled with real income growth should support consumption over the medium term

“The Japanese economy showed resilience in the second quarter 2025, with GDP growth rising by 0.5% q/q and 1.7% y/y. Private consumption and overall investment were solid, offsetting a flat public spending. Exports were strong, adding to growth, while imports were slower, resulting in a positive contribution to growth from net trade.

“Despite concerns over tariffs, Japanese firms, especially in the auto sector, managed to maintain export volumes by squeezing export prices. However, the third quarter is expected to see a slight decline in GDP due to adjustments in export prices and the impact of amendments to the Building Standards Act on private housing investment.

“High-frequency indicators suggest a modest deceleration in growth for the second half of 2025, with large manufacturers’ sentiment improving and consumer confidence rising but the outlook worsening. Yet, services, which
account for nearly 70% of GDP, continue to drive the economy forward, supported by a rebound in tourist flows. Despite a slower third quarter, we expect full-year growth should remain solid at 1.1% y/y.

“Prime Minister Ishiba’s resignation paves the way for some political uncertainty over who the leader will be and how the fiscal package shapes up. These will be crucial not only for the economy but also for asset prices.”

The commentary confirmed the US market may be overpriced in its expectations of consecutive easing moves to be made by the US Federal Reserve at its next several meetings towards the end of the year and into 2026, as the European Central Bank (ECB) remains careful of “not overengineering monetary policy” and mindful of not overreacting to small inflation “deviations” from its target. At the other end of the spectrum, the Bank of Japan (BoJ) is contending with the “curious case” of rice inflation, driving higher prices and creating some risk for households.

“Shelter inflation is easing and will likely continue to do so in our view, but non-housing core services inflation has begun to reaccelerate. The latter is a key area of concern since elevated wage inflation could continue to drive up prices in the most wage-sensitive parts of non-housing core services. Immigration constraints may exacerbate this issue. With goods inflation, the bulk of the tariff impact is likely still ahead of us,” the commentary said.

“A large share of US imports remains duty-free and with importers reducing purchases from high-tariff countries; actual tariffs paid were just over 9% as of June compared to a theoretical rate of 16% based on 2024 import levels. We expect this gap to narrow in the months ahead. Producer prices may well be starting to reflect tariff impacts, and if they continue outpacing consumer prices, corporate profits may weaken, prompting firms to scale back hiring or even consider layoffs.

“Market are anticipating a 25-basis-point interest rate cut in September, followed by another in December. However, rising tariff-driven inflation may limit further easing. In our view, the scope for meaningful declines in short-dated Treasury yields appears limited since Fed policy expected to normalise rather than turn overtly accommodative over the next year.

“Moreover, the bar for the Fed to signal a more aggressive easing stance remains high. At the long end of the yield curve, although term premium narratives have taken a backseat to near-term Fed policy expectations, the overall level of term premium remains elevated. Looking ahead, we expect term premium to rise, with the possibility for some bear steepening.

“As expected, the ECB left the policy rate on hold at its September meeting (at 2.00%) in a unanimous decision. The overall tone of the press conference was broadly unchanged from July, reiterating that the ECB is “still in a good place” but “not on a predetermined rate path.” A few hawkish tones were struck on the outlook and inflation. Growth risks are now seen as more balanced compared to July, mostly due to the US-European Union (EU) trade deal, which supposedly eliminates the risk of higher tariffs and EU retaliation risks (which we were always skeptical about).

“Regarding the near-term outlook, policymakers held a sanguine view of the growth trend in the first half of 2025. On inflation, the ECB noted that “the disinflationary process is over” meaning that most of the moderating forces from previous years will normalise. However, wage growth is expected to decline further, with labor markets expected to remain stable—a fundamental assumption of ECB policymaking.

“The ECB updated its June growth and inflation forecasts. Growth in 2025 was revised higher to 1.2% from 0.9%, while the 2026 forecast was lowered to 1% from 1.1%. Contrary to our expectations, the German frontloaded fiscal stimulus growth impact was not revised higher following the draft budget of late June. In our view, the potential impact has been underestimated. Meanwhile, inflation forecasts were revised down slightly, including confirmation of the undershoot in 2026. In post-meeting comments, President Lagarde expressed that the ECB would not react to minimal inflation deviations from the target, assuming they remain small and temporary.

“Overall, we do not envisage further rate cuts unless growth or inflation materially disappoint over the next six months, with the window for easing progressively narrowing as the German fiscal impulse should become more
visible in 2026. The front-end of the yield curve has been well anchored since post-Liberation Day, with investors pricing out some easing after the ECB’s July meeting.

“There is scope for the curve to steepen in the 1–3-year sector as the German fiscal impulse becomes more tangible. Longer-dated maturities are likely to remain under pressure amid a broader global move and local drivers. As well as higher supply from Germany, anticipated Dutch pension reforms that are due to come into effect in January are expected to weigh on demand.

“The headline consumer price index (CPI) remained strong at 3.1% y/y and core CPI (excluding fresh food) also at 3.1% y/y. Government subsidies have been distorting actual inflation, but underlying inflationary momentum remains strong. Food prices, particularly rice, continue to drive overall inflation, with manufacturers passing on higher costs to output prices. The Tokyo Ku area CPI showed a slight decline in August, but overall inflationary pressures persist.

“Weekly retail rice prices are again ticking up after a dip in June-July indicating that prices are stickier and taking longer to revert to normal despite the government’s measures of releasing stockpiles. Sustained food inflation (especially of staples) can lead to inflationary expectations becoming more entrenched in households, a risk the BoJ has flagged earlier.

“The BoJ is expected to continue its gradual tightening trajectory, with a 25-basis-point rate hike anticipated in October and at least three more in 2026. Wage growth progression and the stickiness of food inflation are key factors likely to influence the BoJ’s future rate decisions. Despite long-end yields reaching record levels, we think the outlook for Japanese Government Bond (JGB) yields remains bearish due to fiscal expansion uncertainties until clarity emerges on Prime Minister Ishiba’s successor.

“Overall, forecasters generally expect the Japanese economy to maintain resilient growth in 2025 and 2026, with GDP averaging 1.1% y/y in 2025 and slowing slightly to 0.8% y/y in 2026. Inflation is forecasted to remain above 3% for the rest of 2025, driven by high food prices and gradual but persistent services prices.”