Brooklyn's Progress
June/July 2007

BY JOEL L. NAROFF, PH.D.,
CHIEF ECONOMIST, COMMERCE BANK

What a strange, strange month May has been. We discovered that the economy nearly dropped under the waves during the first part of the year and inflation finally has begun to moderate. But even as inflation eased, longer-term interest rates surged. And the stock market, which loved the soft economic news, flipped out when the good news appeared. Weird.

Let’s start with the economy. Suddenly, the Bureau of Economic Analysis discovered that first quarter growth was a very meager 0.6%. This was the slowest pace in four years, and given that it is a government statistic, we cannot be certain the economy grew at all. So, are we headed for a recession? Probably not.

The economic data, which had been weak for so many months, suddenly took an upward trajectory. The closely watched Institute for Supply Management’s surveys of manufacturing and non-manufacturing both showed that the economy was coming back. But all was not perfect. Consumer spending was sluggish in April, as households failed to show up at the vehicle dealerships. And while new home sales boomed, existing home demand faltered, raising questions about whether the housing market was even close to turning around. 

In general, the data did point to better economic growth, which should have buoyed investors. It didn’t. The stock markets had a rough few days early in June. Triple digit declines were the order of the day. I guess good news was bad news for investors.

Actually, there is some explanation for the equity market problems. Longer-term interest rates, which had been inexplicably low, suddenly surged. These are rates that affect consumers in many different ways, helping determine things such as fixed rate mortgage and motor vehicle loan rates. Rising rates, which can slow borrowing, are not a friend of the equity markets.

But, although the stock markets may have reacted to rising interest rates, the fact that rates rose is a bit odd. Inflation seems to finally be easing. Normally, long-term rates fall when inflation comes down. In this case, when inflation was rising, rates stayed low and now that inflation is easing, they are rising. 

So what is going on with interest rates? Two factors likely are at work. First, bond investors finally have recognized that inflation is not as low as they thought it would be.  The second is that rates were artificially low because foreign investors were flooding the U.S. with capital. Now that the rest of the world is booming, some of that capital is going elsewhere. As a result, the moderating demand is causing rates to rise. 

When will the rise stop? One thing we know about markets, when the bandwagon gets going, everyone jumps on. Thus, we easily could see rates go above where they will settle over the next few months. Regardless, the rates are more realistic now and do reflect the inflation realities.

So where do we go from here? The Federal Reserve meets at the end of June and likely will do nothing. The economy should continue to improve, but there still does not appear to be any major driving force that would lead to a major acceleration in growth.

Joel L. Naroff, Ph.D., is Chief Economist for Commerce Bank. Commerce Bank, America’s Most Convenient Bank, is a leading financial services retailer with nearly 450 convenient stores in New Jersey, New York, Connecticut, Pennsylvania, Delaware, Washington, DC, Maryland, Virginia and Southeast Florida. Commerce Bancorp (NYSE: CBH) is headquartered in Cherry Hill, NJ and has more than $47 billion in assets. For more information about Commerce, please visit the company’s interactive financial resource center at commerceonline.com.