COMMERCE BANK ECONOMIC REVIEW - April 2006

Watch Out For Rising Rates

By Joel L. Naroff, Ph.D.

The good news is that the labor market is solid; the bad news is that the labor market is solid. And while that may sound like an economist joke, it isn’t. 

What should make us all smile is that the economy is now an efficient job creation machine. U.S. businesses and governments added a very respectable 211,000 new positions in March. The gains were reasonably broad based. Indeed, there were no stars that artificially hyped the employment numbers. In other words, we are not depending upon one sector to keep the economy going.

As job growth has solidified, it has had the expected effect of lowering the unemployment rate. The rate dropped to 4.7% in March. It has been nearly five years since we saw anything lower. Of course, in July 2001, the economy was in the midst of a recession and rates were moving upward, not downward. 

Unfortunately, the good news for workers is not necessarily good news for businesses and, therefore, the Federal Reserve. The stronger the job gains, the weaker the productivity gains, at least that is the usual relationship. The lower the unemployment rate, the faster that wages rise, at least that is the normal relationship. Slower productivity gains and faster rising wages point to rising labor costs of production.

Our businesses operate in a global economy that places tremendous importance on controlling expenses. The rising compensation pressures are adding to already increasing energy and other commodity costs. This could mean higher inflation, lower earnings or what is most likely, a combination of both. 

What does this all mean? The days of low interest rates are basically behind us. Indeed, the reaction to the strong employment numbers and the other solid data that came out during March was swift and sharp. Longer-term rates moved toward 5% and the 30-year Treasury bond broke that level. We haven’t seen rates this high in almost four years. 

For the Fed, the end of the inflation watch is not yet here. On March 28th, the Fed met again. This was the first FOMC meeting for Fed Chairman Bernanke and just like the last fourteen that Mr. Greenspan ran, it ended with a 25-basis-point increase in the funds rate.  We have had fifteen consecutive meetings, spanning twenty months, where short-term rates were hiked by ¼ percentage point. The result – the funds rate now stands at 4.75%. 

So, now we have rising short-term and long-term rates. Mortgages and car loans and most other borrowing costs are on the rise. For example, the rate on the ever popular home equity line of credit is somewhere in the 7.75% range. Fixed rate mortgages are about 6.50% and 1-year ARMs are approaching 6%. 

The economy is in good shape. But the challenges that soaring gasoline prices and rising interest rates present are a concern. In the world of economics, the one constant is that conditions change and they are changing.  

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 400 convenient stores in New Jersey, New York, Connecticut, Pennsylvania, Delaware, Washington, DC, Virginia and southeast Florida. Commerce Bancorp (NYSE: CBH) is headquartered in Cherry Hill, NJ and more than $40 billion in assets. For more information about Commerce, please visit the company’s interactive financial resource center at commerceonline.com.