U.S. Review

Inflation Remains A Top Concern

A larger than expected increase in January’s Consumer Price Index was the only major headline in this past week’s relatively light economic calendar. The overall CPI rose 0.2 percent, while the core increased 0.3 percent. Both gains were 0.1 percentage points ahead of expectations. The larger than expected increase in the core CPI was the most disturbing aspect of this report. The 0.3 percent increase brought the year-to-year change back up to 2.7 percent, which is well below the Fed’s oft stated objective of bringing core inflation back down to around 2 percent.

While the core CPI rose more than expected, it is worth noting that the 0.3% increase was actually rounded up from a gain of 0.256 percent. Moreover, most of the increase was in two components: tobacco, which rose 3.1 percent, and medical care costs, which rose 0.8 percent. Both should be partially reversed in coming months.

Last week, we noted the core CPI had a tendency to post elevated readings in January. The BLS reruns their seasonal adjustment process at the start of each year and sometimes this exaggerates monthly changes.

This is precisely what we believe happened this year. Medical care rose 0.8 percent, which was the largest increase in 15 years. January’s outsized gain follows notably smaller increases in November and December. The introduction of the new prescription drug benefit may have something to do with this increase. The new massive federal program may have changed the timing of when drug companies raise prices and the change was amplified by the new seasonal adjustment factors. This might help explain why drug prices fell in November and December and then soared in January.

Without the spike in medical care and tobacco prices, the core would have risen in line or possibly even below expectations. More importantly, the core CPI has risen at just a 2.0 percent annual rate over the past three months, which is probably much more important to the Fed than the one month blip in the year-to-year change back up to 2.7 percent.

The minutes from the Fed’s January 30/31 FOMC meeting show that inflation remains the preeminent concern at the Federal Reserve. There was some discussion about moving back to a neutral bias, which would imply that the risks of higher inflation and weaker economic growth were about even. Clearly it is too soon for the Fed to make that change. Inflation and growth are moving in the right direction, and this should allow the Fed to hold interest rates steady for an extended period of time.

Other noteworthy reports released this week include another sizeable drop in mortgage applications. Applications for the purchase of a home fell 4.8 percent and are now at their lowest level since October. The drop is consistent with our view that the housing market has not bottomed out just yet.

The flurry in sales activity that occurred late last year was likely driven by aggressive sales incentives from major homebuilders, unseasonably mild weather, and still low mortgage rates. Some of those sales were likely pulled forward. We still expect housing to bottom out this year but the absolute bottom in sales and new construction will probably not be reached until the middle of the year at the earliest.

The index of leading economic indicators also posted a smaller- than-expected increase in January. A decline in the average workweek and a drop in building permits offset gains in the money supply and stock prices. The report is consistent with the economy entering a period of below potential growth, or what is widely referred to as a soft landing.

U.S. Outlook

Existing Home Sales • Tuesday • 10:00

With last week’s weaker-than-expected plunge in January housing starts, all eyes will be squarely focused on sales of existing and new homes sales this week. Sales for both new and existing homes were likely boosted by milder-than-usual weather in November and December. Unlike housing starts, we do not expect to see the kind of pay-back in new and existing home sales. In fact, we expect to see little change in January. However, the MBA’s mortgage application index has been steadily declining since its recent cycle peak at the beginning of the year and suggests to us we are likely to see softer sales starting in February.

While there have been numerous reports suggesting housing may have already bottomed, we suspect the downturn still has a ways to go and do not expect to see a solid bottom to the market until mid-2007. That being said, the downturn has behaved nicely and hasn’t produced any spillover effects yet.

Previous: 6.22 M
Wachovia: 6.24 M
Consensus: 6.24 M

Real GDP • Wednesday • 8:30

The advance reading of real GDP increased a stronger-than-expected 3.5 percent in the fourth quarter. Monthly data reported since the advance GDP release, however, suggest we should see about a full percentage point downward revision to around 2.5 percent. In particular, inventories will likely cut off around 0.8 more percentage points while net trade’s contribution to growth may be shaved a few percentage points below its advance release 1.7 percentage point contribution. Slower construction spending may also weigh on fourth quarter growth.

For each of the past five years, growth in the first quarter has accelerated over the fourth quarter. While the verdict is still out on the pace of fourth quarter growth, we expect to see that trend continue this year. The consumer is still in a solid position and should continue to be the primary driver of economic growth for the remainder of the year.

Previous: 3.5%
Wachovia: 2.5%
Consensus: 2.3%

ISM Manufacturing Index • Thursday • 10:00

The Institute for Supply Management’s index of business activity in the manufacturing sector slipped to 49.3 in January, marking the second time in three months the headline index has dipped below 50.0 (the expansion/contraction level). January’s decline was primarily the result of a substantial decline in the inventories index.

The regional manufacturing surveys released to date have been mixed and suggest little change for the national manufacturing index. The Empire State index posted a solid increase while the Philadelphia Index deteriorated. Despite the mixed regional reports, we see the ISM manufacturing index posting a modest increase in February as the inventory picture should begin to stabilize. We expect manufacturing activity to reaccelerate again this year as the housing market situation lightens and the overall economy remains solid.

Previous: 49.3
Wachovia: 49.8
Consensus: 50.0

Global Review

Bank of Japan Hikes Rates Again.

The Bank of Japan (BoJ) hiked its main policy rate by 25 basis points this week, the first time since July that the BoJ has changed policy (see graph at left). Last week’s release of stronger-than-expected Japanese GDP data, which grew at an annualized rate of 4.8% in the fourth quarter relative to the previous quarter, gave the BoJ the excuse it needed to hike rates. However, the BoJ caved in to government pressure last month to keep rates on hold, so a rate hike this week was not necessarily a slam dunk.

As shown on page 5, CPI inflation in Japan is essentially non-existent at present. So why is the BoJ in a hurry to raise rates? As noted in the press release announcing the rate hike, the BoJ believes that an extended period of excessively low interest rates could eventually lead to speculative bubbles in asset prices. With the economy no longer needing the stimulation of excessively low interest rates, the BoJ is simply in the process of normalizing rates. However, the BoJ also made it clear that rates would remain relatively low “for some time.” In other words, the BoJ is not about to go marching off on some mad tightening cycle. The Japanese yield curve is priced for another 25 basis point rate hike by the fourth quarter, which accords with our expectation as well.

Some investors fret that BoJ rate hikes could lead to a sudden unwinding of so-called yen carry trades, in which investors finance high-yielding investments by borrowing Japanese yen at low interest rates. (For more on yen carry trades, see our two special reports, which are posted at www.wachovia.com/economics.) The sudden unwinding of these trades in the autumn of 1998 led to significant financial market volatility at that time. However, only if BoJ tightening proceeds at a faster pace than currently expected would a dramatic unwinding of carry trades become a real possibility. Until Japanese inflationary pressures become more acute, which does not seem likely in the near term, BoJ tightening likely will proceed at a very gradual pace.

ECB Looks Set to Hike Rates Again in March

Speaking of rate hikes, this week’s data in the Eurozone did little to dispel expectations that the European Central Bank (ECB) will hike rates by another 25 basis points at its next policy meeting on March 8 (see graph on front page). The Ifo index of German business sentiment declined for a second month in a row in February, but it remains near the 15-year high that was set in December. Although the 3 percentage point increase in the value added tax that took effect on January 1 may have pulled some spending into the fourth quarter of last year, it appears that German economic activity generally remains rather solid. Moreover, the sharp rise in French consumer spending in January makes it appear likely that French GDP growth in the first quarter will outpace the 2.6% annualized growth rate that was registered in the fourth quarter. In addition, business confidence indicators in both France and Italy rebounded in February. Given the view among most ECB policymakers that monetary policy is accommodative at present, another rate hike in two weeks looks like a done deal.

Global Outlook

German Unemployment • Wednesday

The upturn that has been in place in Germany over the past few years has led to a noticeable decline in the pan-German unemployment rate. Although still high by U.S. standards, the German unemployment rate currently stands near a 5-year low. The consensus forecast looks for the rate to decline from 9.5% in January to 9.4% in February. Continued tightening of the German (and more broadly, Eurozone) labor market likely would lead to another ECB rate hike or two in the months ahead.

Previous: 9.5%
Consensus: 9.4%

European Manufacturing PMI’s • Thursday

The manufacturing PMI’s in the Eurozone and the United Kingdom both stand above 50, which indicates that activity in the respective manufacturing sectors is expanding. However, the Eurozone PMI has been trending lower over the past few months, suggesting that manufacturing activity is still expanding albeit it at a slower rate than last summer. Will the hike in the German VAT that took effect on January 1 lead to slower growth in manufacturing production in Germany and the broader Eurozone? The PMI index may shed some light on this question. What about the United Kingdom? Was the rise in January a one-month aberration or the start of a stronger trend?

Previous: Eurozone - 55.5, U.K. - 52.8
Consensus: Eurozone - 55.8, U.K. - 53.0

Japanese CPI Inflation • Friday

As noted in the international section above, the Bank of Japan hiked rates by 25 basis points this week. Although inflation currently is benign, the BoJ worries that accommodative monetary policy could eventually lead to much higher inflation. However, the near-term outlook is for further declines in the inflation rate. Energy prices fell in January, which should help to pull down the year-over-year rate of overall CPI inflation. However, the BoJ, and by implication, investors, will be more interested in the “core” rate of inflation. An upturn in “core” CPI inflation in the months ahead could lead to more BoJ rate hikes than currently priced in to the Japanese yield curve.

Previous: 0.3% (year - over-year)
Consensus: 0.0% (year - over-year)

Point of View

Interest Rate Watch

Inflation Data Support Range Bound Market

This week’s consumer price data support our view that the Federal Reserve remains on hold for a while and that ten year Treasury rates remain in a range of 4.60 to 4.90 percent for this year.

Inflation, while not accelerating, continues to grow at a pace slightly above the Fed’s perceived ceiling of two percent. Our outlook is for the core (ex-food and energy) Personal Consumption Expenditure (PCE) deflator to remain in the 2.2 to 2.4 range in 2007 and thereby leave no leeway for the Fed to ease policy. Yesterday’s core CPI data revealed a three month gain of 2.0 percent while the year-over-year gain of inflation was 2.7 percent. Health care gains were 4.3 percent year-over-year.

Two Mandates: Growth and Inflation

Fed policymakers face two mandates - growth and inflation. At this point in the economic expansion neither is significantly different from target values to warrant a move by the financial markets.

Growth, at our estimate of 2.6 percent for 2007, may be disappointing to many but the unemployment rate remains fairly low relative to most analysts’ estimate of full employment. Therefore, there is not a mandate to ease for the Fed and no mandate in the bond market to rally on weak economy news.

At the same time, inflation is not so elevated and not so obviously accelerating such that the Fed is ready to raise rates or the bond market will break the 5 percent barrier.

Economic expansions of the 1980s and 1990s both experienced sustained periods of relative interest rate stability and we are probably seeing the same today.

The New Weekly

This edition marks the first publication of a new format for the Weekly Economic & Financial Commentary.

As we are always striving to improve our coverage, we have taken the opportunity in this redesign to enhance our coverage in several key areas.

The Week Ahead

On pages 3 and 5 of the Weekly Economic & Financial Commentary you will now find outlooks for the key upcoming economic indicators over the next week. This coverage will replace the Monday Morning Outlook with which some of you may have been familiar. As we noted in last week’s distribution, we are discontinuing the Monday Morning Outlook in favor of our new combined coverage. We hope that by combing our outlook for the week ahead and our summary of the week gone by, we will be able to provide you with a more complete economic picture in a more concise format each week.

Global Coverage

We have expanded our coverage of the global economy and will now be providing a look at the week ahead for the major global economies as well as the US economy. Look for enhanced international coverage on pages 4 through 7.

In addition to highlighting the three key indicators for the week ahead, the major global indicators for each day will be added to our calendar on page 7. We hope this expanded calendar gives you a quick view of the week ahead for not only the US but also the major global economies.

As always, we welcome your feedback and comments as our coverage continues to evolve. We hope you enjoy our new Weekly Economic & Financial Commentary.

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Wachovia Corporation
http://www.wachovia.com

Disclaimer: The information and opinions herein are for general information use only. Wachovia Corporation and its affiliates, including Wachovia Bank, N.A., do not guarantee their accuracy or completeness, nor does Wachovia Corporation or any of its affiliates, including Wachovia Bank, N.A., assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or any foreign exchange transaction, or as personalized investment advice. Securities and foreign exchange transactions are not FDIC-insured, are not bank-guaranteed, and may lose value.

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