NEWS / Foreign Exchange

February PCE ??“ Baby, It Was Cold Outside

In real terms, February Personal Consumption Expenditures (PCE) increased by 0.2% after January??™s 0.3% rise. It was a 0.5% increase in real service sector spending that yielded a positive change on overall real PCE. Real durable goods expenditures fell 0.1% and real nondurable goods expenditures fell 0.4%. Real PCE services increased 0.5%, fueled by a 9.5% rise in expenditures for household utilities (electricity and gas). As you may recall, February was considerably colder than usual. In fact, in terms of heating degree days, February 2007 was the coldest February since that of 1979. March warmed up. The question is whether households spent their March savings on utilities at the malls or saved these savings. Given that their saving rate remains at Great Depression level lows ??“ that is, they are running a deficit ??“ and given all the angst about the value of their main retirement nest egg, their homes, I have a feeling they did not hit the malls with vigor in March. The January-February average of real PCE suggests that first-quarter average real PCE is likely to come in at an annualized pace of about 3-1/2% -- down from the fourth quarter??™s annualized growth of 4.2%. Quarterly-averaging arithmetic and economic theory point to a further deceleration in real PCE growth in the second quarter. The February durable goods orders data reported earlier this week suggest that real expenditures on business equipment and software will contract for the second quarter in a row. Putting it all together, it looks as though first-quarter real GDP growth will be below 2-1/2%. The FOMC can live with that, but given the slower trajectory of real PCE growth, the ongoing turmoil in the residential real estate market and that ???the magnitude of the slowdown [in business capital expenditures] has been somewhat greater than would be expected given the normal evolution of the business cycle,??? the Fed must be getting more nervous about the prospects for a recession later this year.

The FOMC might be nervous about the higher probabilities of a recession, but it has to keep up its guard about the prospects of an upside breakout in consumer inflation. The core PCE price index increased 0.3% month-to-month in February and 2.40% year-over-year. Most of the moderation in year-over-year core PCE inflation has been erased from its cycle high of 2.44% set back in August 2006. Although increases in the rent of shelter ??“ explicit and imputed ??“ continue to raise the roof on core inflation, apparel and medical care prices are accelerating. The faster pace of apparel prices could be due to the decline in the dollar. Rent increases are likely to moderate with condo-flippers desperate to bring in a little monthly income to help pay the mortgage, taxes, insurance and condo fees on their empty investments. And inflation is a lagging indicator. The FOMC surely is aware of all this but because it still does not have a lot of Street cred, it has to continue to threaten to commence again in raising the fed funds rate even though it is loathe to do so.

Sweden??™s Riksbank Continues To Sound Sanguine But Rates May Need To Go Up Faster Than Anticipated

As expected, the Riksbank today left its key repo rate at 3.25% and struck the same relativelydovish tone that it adopted after February??™s 25bp rate hike. The bank once again noted that, ???over the coming months the repo rate will need to be raised by 0.25 percentage point ??¦ After that it will probably be possible to pause before making a further increase.??? The bank published its rate path forecast for the first time in February, indicating that it expected the repo rate to be at 3.5% by the end of this year, nudging upward to average 3.6% in Q1 2008 and 3.7% in Q1 2009. However, we think the path of tightening will end up being a little steeper.

The Riksbank targets underlying inflation (UND1X, ex-indirect taxes and interest rates) of 2.0% over a two-year forecast horizon. As we??™ve noted before (see Daily Global Commentary, December 15: Sweden??™s Riksbank Continues On Its Tightening Path), although UND1X remains well below this level ??“ coming in at just 1.3% in February ??“ the Riksbank is concerned with where inflation will be two years from now. There are some signs that inflation may be starting to edge upward, with the headline rate reaching 2.0% last month. Hence, the central bank??™s forecast for gradual tightening.

In today??™s announcement the Riksbank warned that wage deals may fuel inflation. Indeed, industrial workers inked a bigger-than-expected three-year pay deal earlier this month and retail workers just did the same. The labor market continues to tighten, with the (unadjusted) jobless rate falling to 4.8% in February from 5.3% in January. The central bank had been assuming that an expanding labor supply would help to keep some slack in the job market and reduce inflationary pressures. While the labor force has been rising in recent months, February??™s 4.646 million was up only 1.15% on the year-earlier level, which does not seem like enough of an increase to keep inflationary pressures from other sources in check.

Overall, the economy is downright robust. Real GDP growth jumped 1.2% on the quarter and 4.7% on the year in Q4, taking 2006 growth to 4.4% ??“ the fastest since the dot-com boom year of 1999 and the second-fastest since 1970. Evidence so far from the first quarter suggests that this pace continues. Business confidence remains strong and retail sales, though volatile, remain at a high level. The National Institute for Economic Research just raised its forecast for economic growth to 3.9% this year and 3.4% in 2008. The government is a tad more cautious, with growth forecasts of 3.7% and 3.3%, respectively. The Riksbank??™s latest forecast is for 3.5% growth this year slowing to just 2.9% in 2008 ??“ we suspect these numbers will be revised upward in the coming months.

Meanwhile, with the fiscal surplus reportedly rising steadily as the booming economy generates strong revenue growth, Finance Minister Borg said recently he would consider additional income tax cuts in the 2008 budget. Coming on top of this year??™s cuts, that would give an additional kick to domestic demand going forward ??“ something the central bank will likely take into account as it prepares its next set of interest rate forecasts (which will be included in the second Monetary Policy Report of the year, to be released June 20).

We suspect that, if the labor market and growth data continue on their recent trajectory, the Riksbank will sound a little more hawkish at the May 3-4 policy meeting, and will hike the repo rate to 3.50% on June 19-20. How soon the next tightening comes will depend on the data.