Watch the PCE

Although the employment and GDP numbers get more headline treatment, the Fed purportedly keeps a close eye on the personal consumption expenditure (PCE) portion of the Personal Income and Spending report. In recent months, the core PCE deflator has been running above the 2.0 percent mark on a year-over-year basis, which is said to be a line in the sand for the Fed.

According to data from Briefing. com, the January PCE reading came in at 2.3 percent year over year, with the November and December 2006 readings both at 2.2 percent.

“In order for the Fed to cut rates, the PCE needs to fall below 2.0 percent,” says Tim Mazanec, currency strategist at Investor’s Bank & Trust.

Rogers says the Fed is caught between a rock and a hard place as core inflation remains higher than they would like, while economic conditions are softening.

Paul Kasriel, director of economic research at the Northern Trust Co., calls current levels of monetary policy “restrictive.” He forecasts continued soft growth below 2.5 percent, but also expects core inflation to moderate in the months ahead. Kasriel expects a cut in the funds rate in the second half of the year. One piece of the inflation puzzle Kasriel has been monitoring is rents. He cites a record supply of empty houses and condos on the market that could be turned into rentals.

“Most of the pressure on the core rate of inflation is in the service sector,” he says. “A big part of that are rents. Many are owned by speculative buyers who are carrying a mortgage, property taxes, and maybe a condo association fee. Something is better than nothing.”

Kasriel expects moderation in the core level of inflation, which will allow the Fed to take out anti-recession insurance in the form of a monetary ease, perhaps at the August meeting, he says.

BNP Paribas’ Fabbri predicts aggressive Fed easing over the next several quarters. He currently forecasts GDP growth in the neighborhood of 1.5 percent to 2.0 percent in 2007, which he says is conditional on Fed easing actually occurring.

“I think job growth will slow fairly significantly relative to last year,” he says. “Less job growth equals less income, which means consumers have less money to spend.”

According to Fabbri, chances for a recession are around 10 to 15 percent. But he also expects the Fed to reduce the funds target to 4 percent by year-end.