Citi expects Sweden to keep repo rate intact

Headline inflation in Sweden dropped by 0.2% m/m in July and increased by 1.9% y/y reports Citigroup Research with underlying inflation (UND1X) – the Riksbank’s preferred measure – posting a 0.3% m/m decline, leaving the annual inflation rate unchanged at 1.0% in July, in line with Citi and market consensus expectations.

Summer clothing and footwear sales contributed by 0.5 percentage points (pp) to the drop in headline CPI on a monthly basis. The tax increase on traffic insurance and mortgage rates pulled in the opposite direction. The latter factors, though, do not affect UND1X as this measure excludes the changes in the direct effect of indirect taxes and subsidies.

Price pressures in the Swedish economy are slowly beginning to build, and underlying inflation has consistently exceeded the Riksbank’s projection for the past several months. In June, the Riksbank published its second Monetary Policy Report of this year, including new macro economic and financial forecasts. On the inflation front, the Riksbank expressed concerns about the outcome of the wage agreements, and combined with a tighter labour market and more subdued productivity growth, the central bank lifted its forecast for underlying inflation. Still, core inflation once again came out on the high side, overshooting the Riksbank’s new inflation estimate by 0.2%-point (see Figure 1). Reflecting the expectation of rising inflationary pressures, the Riksbank also lifted its interest rate path in the June MPR (to 4% end-2007 from 3.5%, to 4.2% mid-2008 from 3.6% and to 4.4% mid-2009 from 3.7%).

Inflation remains muted, but core inflation continues to overshoot the Riksbank’s projections – even with the upward revision of these in the latest Monetary Policy Report, notes Citigroup Research. “Today’s inflation numbers, though, are not expected to alter the central bank’s view. What is more important for the bank is the inflation outlook. Here the subdued productivity growth, the downward trend in unemployment and accelerating labour costs likely pose major concerns for the central bank.”

In terms of monetary policy, today’s inflation numbers do not alter Citi’s interest rate profile. And with the economy still going strong, Citigroup analysts continue to expect the next rate hike of 25bp to 3.75% at the September 7 meeting. By year-end, Citi analysts project the repo rate at 4.00%, but acknowledge that risks are slightly on the upside given the surprisingly strong GDP growth in the second quarter (3.6% y/y). 

“If, as we expect, external pressures become less disinflationary over time, while domestic capacity pressures continue to build, then in practice the Riksbank will probably have to revise up its projections for the optimal interest rate path further in coming quarters. Therefore, we feel comfortable with our view that the repo rate will stand at 4.75% by end-2008,” conclude Citigroup analysts.