US
Review and Preview
Jan 16, 2006

Ted Wieseman (New York) and David Greenlaw (New York)

Treasuries posted a second week of modest gains to start off the new year over the past week. It was a fairly volatile week for a period with very little in the way of significant fundamental news until Friday, and, indeed, it appeared that more technical and flow driven moves dominated activity through the first part of the week before a positive reaction to weaker than expected retail sales and a lower than expected increase in core PPI ended the week with a solid fundamentally based rally. Prior to that, the market saw significant 10-year futures-led weakness through Wednesday that appeared to be mostly technical in nature. Particularly in the case of the week’s biggest down day on Tuesday, a strong German ZEW survey overnight and associated weakness in European government bonds led to some initial softness in Treasuries as well, which accelerated when 10-year futures -- which recent reports have indicated have high levels of net long positions by speculative accounts -- broke through perceived support levels in a pretty much news free day. This futures-led weakness amid a fundamental news drought extended into Wednesday, before much of the prior weakness was reversed Thursday in what appeared pretty obviously to be some significant, again futures-led, asset allocation flows, as S&P futures sudden broke sharply lower, simultaneous with a sharp rally in futures in late trading.

It was only Friday, when we finally received some key economic data, that investor focus returned to more fundamental considerations, and better than expected results from the retail sales and PPI reports prompted a sharp rally, moving the market into modestly net positive territory for the week as a whole. While until Friday it received little market attention, there actually was a fair amount of data over the past week that affected our fourth quarter GDP estimates -- wholesale inventories, trade, the Treasury budget statement, retail sales, and retail inventories -- but all in all, while there were some meaningful offsetting moves, the net didn’t amount to much, as we trimmed our Q4 GDP forecast to +3.1% from +3.2% (but with a larger negative mix shift towards less final sales and more inventory accumulation). While Q4 thus appears set up for a mild slowing in the recent growth trend (much more so looking at what is expected to be only a marginal increase in final sales, with almost all the expected growth coming from an inventory rebound), the sharp gain in December retail sales on top of the strong advance in November highlighted the strong momentum the economy carried into Q1, when we forecast GDP growth will accelerate to +4.2%.

On the week, benchmark Treasury yields fell 3 to 4 bp, reversing losses of 7 to 8 bp through Wednesday with a strong turnaround Thursday and Friday. There were slight flattenings at the shorter and longer ends of the curve, with the 3-year and 5-year yields down 4 bp each to 4.29% and 4.28%, respectively, versus a 3 bp decline in the 2-year yield to 4.33%, while a 4 bp drop in the long bond yield to 4.525% outperformed a 3 bp decline in the 10-year yield 4.35%. Much more so than these moves in the cash market, it was really futures that drove the week’s activity, in particular the 10-year contract, which significantly underperformed and was the focal point of the selling during the market’s down leg earlier in the week and then outperformed notably in the subsequent rally.

Technical breakdowns amid the dearth of early week news appeared to be the prime driver of the 10-year futures-led selling through Wednesday, while a futures-led bonds for stocks asset reallocation seemed to be the key impetus helping get the rebound moving Thursday afternoon, with a more fundamentally based rationale providing for extended upside Friday.

This futures focus was also reflected in strong relative gains in eurodollars in the late week rally led by the late 2007 and 2008 contracts, with the result that while there was essentially no change in near-term Fed pricing, the amount of easing priced from mid-2006 surged to new highs. On the week, the rate on the February fed funds contract rose a half bp to 4.49%, still fully pricing in a 25 bp rate hike at the January 31 FOMC meeting. The April contract rallied 1 bp to 4.64%, putting slightly more than even odds to a move to 4.75% in March. If not in March, the final move to 4.75% is expected by the market with a pretty high probability to come in May, with the June contract flat on the week at 4.685%. Beyond then, however, more rate cuts are now expected. The June 06 to June 07 inversion reached consecutive all-time lows Thursday and Friday, ending the week 6 bp flatter at -18.5 bp, with the former contract ticking up 0.5 bp to 4.78% and the latter rallying 6.5 bp to 4.595%

There was a light economic calendar the past week that only really attracted market interest on Friday when the week’s two most noteworthy releases, retail sales and PPI, proved better than expected on a headline basis. Underlying details of the reports really didn’t seem as notably positive as the market seemed to perceive the headline results to be (judging from the strong Treasury market rally they engendered).

In particular, while ex auto retail sales rose less than expected in December and while there were downward revisions to prior months, the softness was largely in the building materials component, which is not included in the “retail control” grouping that is a key input into GDP consumption estimates. Indeed the rise in retail control (retail sales less motor vehicle dealers and building materials stores) reached 0.3% in December, only a bit less than we expected, and there was a slight upward revision to prior months. As a result, we only trimmed our Q4 consumption estimate marginally to +0.2% from +0.3%. Obviously this would be a pretty poor outcome, but it’s crucial to keep in mind that the softness for the quarter as a whole totally reflects the collapse in auto sales from July to October. This weakness started Q4 off in such a hole that even the robust sales gains in November and December appear to only have returned consumption for the quarter as a whole back into barely positive growth territory. But as a result of the November and December strength, the reverse of the Q4 pattern now prevails as we enter Q1, and it will require only meager (roughly 0.2% a month) gains in real spending from January to March to leave consumption in the first quarter running above 4% -- the key driver of our forecast that overall GDP growth will accelerate from +3.1% in Q4 to +4.2% in Q1.

Meanwhile, core PPI rose less than expected for a third straight month, but for the third straight month, the surprise was more than accounted for by weakness in volatile car and truck prices, which we are far from convinced are being accurately measured on month-to-month basis in these data. And while there certainly was an increase in incentives in December, we think it quite likely that the collapse in car and light truck prices the past three months that has left motor vehicle price inflation on a year/year basis at a near record low overstates the true situation and that auto prices are due for some rebound in coming months in the PPI report. Meanwhile, the ex auto core PPI has continued to show some acceleration in recent months, with increasing pricing power being shown by capital goods producers.

In addition to the retail sales report, there were a number of other less noted releases the past week that impacted our Q4 GDP forecast. On the positive side, both wholesale and ex auto retail inventories rose more in November than we expected, and industry data indicated that unit truck inventories fell less. On the negative side, in addition to the slight downside in consumption, the Treasury budget results for December pointed to significantly slower growth in federal defense spending in Q4 (indeed essentially no growth by our estimates) than we had previously assumed. Meanwhile, the trade report was about neutral overall -- the nominal deficit narrowed more than expected, but this was not fully reflected in the constant dollar figures, and the capital goods import and export figures pointed to slower domestic investment than we had previously assumed. Putting together all the directly GDP relevant data released during the week, we trimmed our Q4 estimate marginally to +3.1% from +3.2%. The mix shift was a bit more negative than this, however, as we cut our estimate of final sales about a half point to +0.4%, which was nearly fully offset by an even higher estimated inventory rebound after the outright liquidations recorded in Q2 and Q3.

Key data releases the past week were trade, Treasury budget, retail sales, and PPI:

* The trade deficit narrowed to $64.2 billion in November from a record

$68.1 billion in October, with exports jumping 1.8% and imports falling 1.1%. The upside in exports was led by capital goods, particularly aircraft, which saw a second straight sharp rise after the Boeing strike depressed shipments in September. Most of the pullback in imports was in petroleum products and natural gas. Surprisingly, however, the entire petroleum drop was price-related, as volumes actually surged a further 6.8% on top of the 6.5% rebound in October from a hurricane impacted drop in September. Consumer goods imports also showed a significant decline, in line with recent slowing in inbound cargo growth at the key West Coast ports, pointing to some moderation in Asian imports.

* The federal government ran a budget surplus of $11 billion in December, up from a $3 billion deficit a year before. Revenues jumped 12.1% Y/Y, while spending increased 5.6%. The majority of the revenue upside reflected a 32% surge in net corporate receipts, which were probably boosted significantly by repatriation of overseas profits at now expired advantageous tax rates. Through the first three months of FY2006, the federal government has run a deficit of $119 billion, about unchanged from the same period in FY2005. We expect revenue growth to slow and spending growth (boosted by Katrina rebuilding and the Medicare drug plan) to pick up going forward and forecast a full FY2006 deficit of $400 billion, up from $318 billion in FY2005.

* Retail sales rose 0.7% in December overall and 0.2% ex autos, slightly less than expected. Reflecting the strong advance in unit sales, auto dealers’ receipts jumped 2.6%, accounting for most of the rise in overall sales. Mildly disappointing results relative to previously reported chain store sales held down ex auto sales, most notably general merchandise (-0.3%) and electronics and appliance (-0.1%) stores.

Building materials stores (-0.6%) also started to retrace some of the extraordinary surge (+19% annualized) over the prior four months that likely in large part reflected hurricane preparation and rebuilding. The key retail “control” component (which excludes motor vehicles and building materials) rose 0.3% and there were slight upward revisions to prior months.

* The producer price index surged 0.9% in December -- bringing the full year gain to +5.4%, the largest calendar year rise in 15 years -- boosted by upside in both food (+0.9%) and energy (+3.1%), the latter mostly reflecting a 12% spike in gasoline prices that was almost entirely a result of a large seasonal add factor in December. Meanwhile, the core PPI rose a less than expected 0.1%, restrained for a third straight month by downside in car (-0.2%) and light truck (-1.0%) prices. Combined motor vehicle prices were down a near record 4.5% Y/Y in December, which likely overstates actual pricing trends. Excluding autos, the core rose 0.3% for a second straight month, a mild acceleration from the prior trend, with upside in various capital goods the main contributor.

The upcoming holiday shortened week has a fairly busy economic calendar, highlighted by the CPI report on Wednesday, which we expect to extend the recent trend of mild upside in the core. As we rapidly approach the January 31 FOMC meeting, Fed news will also be a focus, with the Beige Book released Wednesday and several speakers scheduled to talk about the economic outlook, including Governor Bies Wednesday, Richmond Fed President Lacker Wednesday and Friday, and Atlanta Fed President Guynn and San Francisco Fed President Yellen Thursday. In addition to the CPI report, a main data focus will be reports providing an early glimpse at key upcoming data for January, with the Empire State and Philly Fed manufacturing surveys Tuesday and Thursday giving an advance indication for the ISM and initial jobless claims this week covering the survey period for the January employment report. The Morgan Stanley Business Conditions Index (based on a survey of our equity research analysts) slipped in January from a very elevated level in December (see the article “Business Conditions: Testing the Strong Growth Thesis” by Shital Patel and Dick Berner for details). So we expect to see some pullback in the Empire gauge, which also stood at a relatively high level in December, but probably less so in the Philly report, which was already quite a bit lower than the Empire last month.

On the claims report, although this week’s figure will cover the survey week, we suspect that more seasonal adjustment problems will make the results uninformative. For some reason for a second time in the past few weeks the seasonal factor for initial claims is much different from the last time we had an identical calendar, despite those prior factors having apparently performed quite well. In the week of December 31, the seasonal factor for initial claims was far friendlier than the last time we had the same calendar and the result was a, in our view, largely spurious 34,000 collapse in initial claims. The seasonal factor this week appears to questionably swing even more in the other direction, and we look for a spurious corresponding move in claims, with initial claims expected to spike 51,000 to 360,000 -- a result that we don’t believe would tell us anything useful about the likely outcome of the January employment report. Other data due out in the coming week include industrial production Tuesday, housing starts Thursday, and the University of Michigan consumer confidence survey Friday (which based on the continued improvement in the weekly ABC/Washington Post poll should extend its post-Katrina rebound).

* We forecast a 0.6% rise in December industrial production. The labor market report showed that hours worked in the factory sector were little changed in December. However, API data point to some further recovery in oil refining operations, and auto assembly schedules imply a modest gain in vehicle production. So, we look for a 0.5% rise in the manufacturing component. Some weather-related elevation in utility output, as well as an uptick in oil drilling, accounts for the remainder of the expected increase in overall IP. Finally, the utilization rate should jump to 80.6%, its highest reading in more than five years.

* We look for a 0.2% rise in the December consumer price index, both overall and excluding food and energy. Energy prices appear to have flattened out in December following the wild swings seen in prior months. Meanwhile, we look for some modest upside in the key shelter category driven by the gradual correction in hotel rates and an above trend result for OER. The latter should be impacted by the well known quirk involving utility prices -- in calculating OER, utilities are subtracted from actual rents paid in order to derive a measure of “pure” rent. So, rising fuel prices tend to put some downward pressure on OER and vice versa. Although we expect to see some modest declines in categories such as apparel, used cars and air fares, our unrounded estimate for the core CPI is close to +0.25%, which would match the reading in each of the prior two months. On a year/year basis, we expect the core to tick up to +2.2%.

* We expect December housing starts to fall to 2.02 million units annualized. Although the labor market report showed the first drop in construction jobs in 22 months, much of the weakness was outside of the residential sector. Still, homebuilder surveys have displayed increased pessimism in recent months and we suspect that the underlying pace of new home construction is poised to moderate. We look for about a 5% dip in December starts to a pace that is slightly below the 12-month average.

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Japan
Holding Tight
Jan 16, 2006

Takehiro Sato (Tokyo)

Key Points

What’s changed:

The administration and ruling parties are keeping the economic body temperature warm with a suitable level of asset inflation as part of a strategy to win national support for a consumption tax hike and revisions to the Constitution. This macro policy approach means the continuation of an ideal combination of rising asset prices with a stable long-term rate. A quiet productivity revolution is providing fundamentals support.

Conclusions:

We expect long-term rates to hold in a surprisingly tight range in F2006-07 at 1.3%-1.8%, maintaining the 2% barrier in place since March 1999.

Risks:

We think an unexpected rise in the long-term rate could occur in the following two cases – 1) asset markets overshooting and domestic institutional investors shifting to stocks and foreign bonds and 2) the government and BoJ set an inflation target and win market trust in the method for achieving the target. However, the latter case would partially restore a policy duration effect, anchoring the short- to medium-term zone near zero while causing extreme steepening of the medium- to long-term zone.

Detail

Long-term rate should remain stable even with a reflationary policy

We anticipate an end to the reversal of real and nominal growth rates in F2006 at 2.7% and 2.8% respectively, exceeding the government’s forecast 1.9% and 2.0%, and a 3% nominal growth rate in F2007 with complete elimination of the real-nominal reversal for the deflator. These results should bring Japan out of deflation and meet minimum requirements for returning to the fold of normal advanced economies.

However, Japan must also restore the flexibility of fiscal policy, not only overcome deflation, to be accepted as a normal advanced economy. We expect continued fiscal austerity and ultra-accommodative monetary policy toward achieving the goal of a primary balance surplus in the early 2010s, an important step in this direction. Japan needs to address its national security apparatus as well, besides economic and fiscal normalization, to gain true respect as a normal advanced country. The ultimate target in this area is revision of the Constitution. We see an excellent window of opportunity through 2008 while the Bush administration stays in power or 2009 while the ruling coalition retains its absolute majority in the Lower House.

The administration and ruling parties are keeping the economic body temperature warm with a suitable level of asset inflation as part of a strategy to win national support for a consumption tax hike and revisions to the Constitution. This macro policy approach means the continuation of an ideal combination of rising asset prices with a stable long-term rate. A quiet productivity revolution is providing fundamentals support. We broaden our interest rate forecast along with the extension of our economic outlook to F2007. The development of this productivity revolution on the fundamentals side will help bolster this combination. We expect the long-term interest rates to hold in a surprisingly tight range during F2006-07.

Reconsidering the monetary policy scenario

The core CPI rate was 0% or higher for a second straight month in November, putting Japan close to clearing the first condition (and final hurdle) for the reversal of quantitative easing. We expect another positive result for December due out on January 27. This implies that a reversal could come on February 9 at the earliest. However, we think the BoJ will delay the timing of a reversal to the new fiscal year as an extra precaution and to placate the administration and ruling parties, and anticipate a policy revision along with the release of the Outlook Report on April 28. The revision will return the policy goal from quantity to an interest rate and remove the policy-duration commitment to core CPI. But we maintain our view that a rate hike will be considerably postponed despite the restoration of a “quasi” zero interest-rate policy (“ZIRP”).

Basically, we reiterate our existing forecast for a rate hike of 25bps in Apr-Jun 2007 after official confirmation from Jan-Mar 2007 GDP data released in May 2007 of 2% nominal growth in F2006 (the government’s target for overcoming deflation) weakens political pressure for the BoJ to sustain ZIRP on the basis of continuing deflation and gives the Bank a freer hand. We have to assume healthy economic fundamentals and market conditions in early 2007 and a modest positive trend for core CPI to look for a rate hike at that timing.

Interest rate scenario and background

We modestly lower our long-term interest rate outlook for 2006 based on the macroeconomic and policy environment described above. Although we previously expected a slight rise in the long-term rate during Jan-Mar 2006 ahead of the anticipated policy reversal, the outlook for an immediate rate hike following the reversal has substantially retreated and the long-term rate is likely to stay in a tight range through Jan-Mar 2008. We also think the 2% barrier in place since March 1999 will be maintained during F2006-07.

	Sep.05	Dec.05	Mar.06e	Jun.06e	Sep.06e	Dec.06e	Mar.07e	Jun.07e	Sep.07e	Dec.07e
Call Rate	0.004	0.004	0.001	0.01	0.01	0.01	0.01	0.25	0.25	0.25
3-month Libor	0.03	0.06	0.06	0.06	0.06	0.13	0.25	0.50	0.50	0.50
10 Yr. JGB	1.48	1.47	1.50	1.40	1.40	1.30	1.50	1.70	1.80	1.80

Source: Morgan Stanley Research estimates  Note: end of quarter

Risks

There are obviously risks for the above scenario. Stock prices will enter a valuation zone beyond simple euphoria once TOPIX exceeds 1,700 points. Yet we still expect a stable long-term rate mainly in light of conditions from 1999-2000. The latest market rally, however, involves broad preference on expectations for the economy to pull out of deflation and structural reform progress in contrast to highly lopsided investment in a narrow segment of stocks and lack of overall market improvement in 1999. We therefore expect a stronger capital shift from bond to stocks than in 1999 and can actually confirm this trend from recent movement by the broadly-defined liquidity components in money supply data.

We expect Japan’s long-term rate to stay in a tight range of 1.3%-1.8% during F2006-07 but also acknowledge a risk scenario in which the rate exceeds 2% if the outlook for economic fundamentals continues strengthening and stock prices enter a zone beyond euphoria.

Another possibility (sub-scenario) is upward pressure on the long-term rate from a rise in anticipated inflation if the administration and BoJ agree to set an inflation target or other policy anchor. For example, the anticipated inflation rate might rise if the market interprets a goal for a 1% core CPI rate as central bank approval of inflation. This would put upward pressure on the nominal interest rate.

However, there is risk surrounding whether the anticipated inflation rate would quickly rise in response to an inflation target and follow the ideal pattern described above. Authorities must have reliable ways of achieving inflation target and not just set a target. This poses the question of whether the target can be met just via monetary policy given the restrictions on fiscal policy and addresses market credibility in an inflation target. Yet we anticipate a powerful flattening bias on the yield curve in the short-term zone up to the 2-3 year range from setting an inflation target under disinflation conditions, reflecting a new policy-duration effect.

However, we also find it risky to read too much into the relationship between inflation target and monetary policy. In looking at the actions of the overseas central banks that are using an inflation target, it is by no means consistently basing policy changes on the target inflation rate.  As such, even if the target is not reached, we think an interest rate hike in Apr-Jun 2007 is conceivable.

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Turkey
Loving IT
Jan 16, 2006

Serhan Cevik (from New York)

Inflation targeting is becoming a dominant monetary policy framework around the world. When New Zealand introduced inflation targeting as a monetary policy framework in 1990, no one outside a small cadre of academics and central bankers knew much about inflation targeting. However, with the apparent success of the new regime in achieving and maintaining price stability, the number of countries adopting inflation targeting increased to 13 by the end of the 1990s and to 22 at the end of last year. While many others (including the Bank of Japan) are contemplating the switch, Turkey has become the 23^rd country formally embracing inflation targeting. After managing monetary affairs with an implicit inflation-targeting approach, the Central Bank of Turkey will now target to reduce inflation, measured by the consumer price index, to 5% in 2006 and 4% next year. Operationally, however, policy responses, though aiming to reach the reference points, will accommodate short-term price fluctuations within an ‘uncertainty band’ of 3%-to-7% this year. In our view, this is a prudent strategy that would help in minimising the volatility of other macroeconomic variables, and as Turkey moves closer to price stability, the central bank will no doubt narrow the uncertainty band.

Increasing policy independence and transparency lowers real interest rates. Inflation targeting is all about long-term commitment to price stability. Although such a single-focus policy approach may bring certain risks, it can help in shaping the evolution of inflation expectations and gaining credibility. Even without a nominal anchor, policy independence and enhanced transparency improve a central bank’s effectiveness in managing economic and financial developments and therefore deliver a substantial reduction in real interest rates. Turkey’s experience (even with just an implicit inflation-targeting strategy) is a great case in point. Policy credibility — gauged by the deviation of inflation expectations from the official target — has improved dramatically from 13.3 percentage points in 2002 to 1.1 percentage points in 2004 and then to just 40 basis points last year. In view of that, the volatility of inflation rates has come down to the lowest level in the last four decades, leading to a marked decline in forward-looking real interest rates from an average of 28.5% in 2002 to 13.9% in 2004 and then to 9.2% last year.

Thanks to fiscal and structural reforms, Turkey is now ready for formal inflation targeting. Inflation targeting requires not only institutional strengthening of the central bank, but also a firm foundation built on fiscal consolidation, financial vigour and structural reforms. We believe that Turkey has made significant progress on all these spheres in the last four years and, as a result, is now ready to adopt formal inflation targeting. For example, the sustainability of public finances — a key determinant of inflation expectations that had driven the self-fulfilling inflation process in Turkey — has improved at a remarkable rate, as the public-sector borrowing requirement declined from the peak of 16.4% of GDP in 2001 to 0.8% last year. Likewise, the country’s financial system, albeit still far away from developed-market standards, is now on a stronger footing and rapidly learning to provide intermediation. Together with the de-dollarisation of the economy, the emergence of a proper credit channel will of course strengthen the central bank’s hand in implementing inflation targeting.

Inflation targeting will support the normalisation of Turkey’s macroeconomic landscape. In our view, the inflation process has changed at its core in the post-crisis period, as prudent macroeconomic policies and structural changes in the economy lowered the inflation rate from an average of 77.5% in the 1990s to 7.7% at the end of last year. Even though this is indeed the lowest inflation rate in the last 37 years, it is still above the ‘price stability’ range due to higher commodity prices and the inertia in non-tradable prices. Nevertheless, we believe that Turkey’s new macroeconomic policy framework based on inflation targeting and multi-year fiscal programming will become a bright guiding light for all economic agents at this juncture and keep driving (real) interest rates to a lower plateau.

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Sweden
Global Economic Forum
Jan 16, 2006

Elga Bartsch (London) and Thomas Gade (London)

Reviewing the Repo-Meter and the Riksbank

Conclusion: We expect the Riksbank to embark on a gradual tightening campaign with a 25 bp rate hike at the upcoming Executive Board meeting.  Our new repo-meter model indicates that such a move isn’t a done deal though.  Expectations in some circles for a larger move are likely to be disappointed, we think.

What's New: We have extended our repo-meter model, which contrary to us and the market correctly anticipated the 50 bp cut in June, to Riksbank tightening cycles.  Capturing Riksbank decisions based on economic fundamentals turned out to be tougher for hikes than it was for cuts. In some cases, the SEK seems to have tipped the balance in favour of a rate cut.

Implications:   We expect the initial 25 bp rate hike at the upcoming meeting to be followed by another such move in February.  In total, we expect the Riksbank to hike by 150 bp this year. This compares to market expectations of 125 bp and to 100 bp of ECB tightening projected by us.

Details

After our proprietary repo-meter model — contrary to us and the market — correctly anticipated the 50 bp Riksbank rate cut last June (see Gauging the Probability of a Riksbank Rate Cut, May 17, 2005) many clients have asked for an update now that the start of a tightening cycle looms large in Sweden.   In this note we present our new repo-meter, Version 2.0, which is designed to capture the probability of a Riksbank rate hike. We also discuss the near-term outlook for the Riksbank.  Our repo-meter is a lot less certain than we are and than the market is that the Riksbank will hike the repo rate at the upcoming meeting on January 20.  Compared to our subjective probability of 75% and a consensus of an 80% probability, the repo-meter estimate of merely 4% in January and 27% in February is rather cautious.  But we don’t slavishly follow a statistical model (even though we sometimes live to regret it) and continue to expect a 25 bp rate hike this week.

Crunching the numbers for the repo-meter version 2.0, we found it a lot harder to find a good statistical model that describes the Riksbank’s behaviour in a tightening cycle than it was for version 1.0 capturing Riksbank easing.   For starters, there are fewer rate hikes than rate cuts over our sample period because the Riksbank hiked only seven times, while it cut rates twenty-six times.  The small number of observations implies that for rate hikes the repo-meter is less robust.  But we found a clear indication that, in the past, the Bank’s rate hikes were motivated differently than the rate cuts.  That’s why we need two different models, one for tightening cycle and one for an easing cycle.  It also turned out that at least two Riksbank rate hikes weren’t so much driven by economic fundamentals but by exchange rate considerations.  The statement accompanying the decisions on 6^th December 2000 and 5^th July 2001 seem to confirm the model’s verdict that the exchange rate was probably the main tipping point at the time.  In order to capture these consideration too, we thus constructed a second variant of the rate hike model, which over and above economic fundamentals also includes past exchange rate changes. 

We find that Riksbank rate hikes — like rate cuts — were driven by sentiment indicators, such as business sentiment and consumer confidence, as well as UND1X inflation and year-over-year changes in USD/SEK (see Technical Appendix for details).   Like in an easing cycle, the Riksbank attaches a higher weight to consumer confidence than it does to business confidence.  However, it seems that UNDIX inflation becomes more important when it comes to rate hikes.  And as the new kid on the block, we find the USD/SEK exchange rate to be a decisive factor such that pronounced SEK weakening seems to have triggered rate increases in the past.  This could be because exchange rate changes have a bearing on future inflation in small open economies.  But we find that it is the bilateral exchange rate against the USD rather than that against the euro or the trade-weighted TCW explain rate decisions best. In fact, it seems more likely to us that the role of the USD/SEK reflects the global interest rate cycle and the Swedish position versus that of the Federal Reserve.   Unfortunately, our Repo-meter 2.0 isn’t as reliable yet as the Repo-meter 1.0, which captured Riksbank rate cuts rather well.  But our understanding of the drivers of Riksbank rate hikes should improve going forward as we will likely be able to add more data points to our study.

While our repo-meter model indicates that a rate hike at the upcoming Executive Board meeting is far from a done deal, we believe that the Swedish repo rate will likely be hiked by 25 bp.   This is because there are a number of factors that aren’t captured by the model.  These factors include the signals sent by the Bank’s communication, by the voting of Executive Board members or by the very low level of interest rates and its role in the build-up of financial imbalances.  Indeed if the Riksbank’s interest rate decision could be fully captured by a simple statistical model, we (and the Riksbank) should probably find ourselves another pastime. 

Since the Riksbank’s decision to lower the repo rate to 1.50% in June 2005, nominal three-month rates and ten-year bond yields have been hitting historical lows.   Also, real rates have been close to record lows.  Briefly in 2002 and 2003, real interest rates were lower than at present, but at the time the drop in real interest rates was due to a pick up in inflation.  With an economy likely to grow above potential, which we estimate to be around 2.5%, for the third consecutive year, the low level of interest rates has become increasingly worrisome.  With the possibility of a slowdown in global growth in 2007, also discussed by the Riksbank according to the Minutes, the Riksbank might want to reload its monetary policy gun.  All in all, the Riksbank will want to embark on a policy normalization path sooner rather than later.  As the repo meter model looks at a change in the repo rate, the level of interest rates is not explicitly included in the model. 

Also, the recent asset price appreciation and debt build-up in the household sector is a factor to which the Riksbank has given more attention lately. To some extent, the positive wealth effects of rising house prices and equity markets are echoed in our repo-meter through the level of consumer confidence.   We find that the lagged growth rate of equity prices and property prices has been closely correlated with the level of consumer confidence (with a correlation coefficient of up to 83%).  The Riksbank might become concerned about the debt increase that typically follows the increase in household debt.  In particular, with the new Governor Stefan Ingves and his background in dealing with the Swedish banking crisis of the early 1990s and in assessing the stability of various financial sectors at the IMF, these considerations might take more room in the future.  To curb the potential financial instability that could result from a continuous strong pace of asset-price appreciation and debt build up, the Riksbank will be keen on slowing this process by starting to normalize interest rates, we think. Also, the Minutes of the December Executive Board meeting and recent signals from Board members indicate that Swedish interest rates are likely to go up.  At the December meeting, the decision to leave rates unchanged was razor-thin.  Only the casting vote of the outgoing Governor, Lars Heikensten, tipped the balance towards a holding operation (see Minutes Points to 25 Basis Point Rate Hike in January, Dec 15 2005).  At that meeting, three members voted for a 25 basis point rate increase, Lars Nyberg, Villy Bergstroem and Eva Srejber.  At the beginning of this year, Governor Heikensten and Deputy Governor Bergstroem were replaced by Stefan Ingves as the new Governor and Svante Oeberg as a new Deputy Governor.  We expect Lars Nyberg and Eva Srejber to vote for an increase in interest rates again at the upcoming meeting. 

On Friday, Irma Rosenberg, who is responsible for preparing the Inflation Report as well as the Monetary Policy proposals, stated that it is time to take the first step towards normalising the level of interest rates, and she would support a gradual increase in rates. From that, we read that the first step will be taken at next week’s monetary policy meeting, that the step will be gradual, i.e. 25 basis points, and that there is more to come, i.e. the normalization of the repo rate.   The decision of Irma Rosenberg to support a rate hike would mean that at least three out of the six-member Executive Board will vote for a rate hike.  Our sense is that Governor Stefan Ingves is likely to be in favour of a rate increase as well, given his merits in the area of financial stability. Also he would be unlikely to apply his casting vote at his inaugural meeting, we think. All in all, we thus expect a 25 basis point increase in the repo-rate to 1.75% to be announced this Friday.

We gratefully acknowledge the contribution of Arun Navaratna to this report

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