COMMERCE BANK ECONOMIC REVIEW - August 2006

In the Face of Rising Inflation, the Fed Pauses

By Joel L. Naroff, Ph.D.

Hot. That is what the weather has been. Not so hot. That is the description of the economy. The strains on corporations and households continued to grow in July as the housing market softened further, energy prices surged and the labor markets weakened.  The cost of living and the cost of doing business seemed to do nothing but rise. In the midst of it all, the Federal Reserve decided that it had done enough and finally stopped raising rates. Yet, in spite of it all, there are no signs of a major economic slowdown let alone a recession. That’s good news.

Is it all about inflation or is it all about growth? For the longest period of time, the Federal Reserve indicated that inflation was “job one”. And there was very good reason. Petroleum prices seemed to set new highs every day and more households started directly depositing their paychecks into the gas pumps. 

But, just as some resemblance of reality seemed to set in at the Fed, the members decided they didn’t have to take further action to slow inflation. They actually didn’t increase interest rates at their latest meeting. This may seem strange, but the members had been raising rates for more than two years. Eventually, rates had to get high enough to start restraining economic growth, which was needed to dampen the inflationary fires. They just may be there already.

While the inflation readings were spiraling upward, the temperature of the economy started to drop. With both existing and new home sales faltering, construction activity started to take a dive. Home prices were falling just about everywhere except where I am looking to buy. That will probably change, but only after I buy my house. So it goes. 

But it wasn’t just the housing market and my car that were running on empty. The labor market seems to running out of gas as well. Job gains in July were so disappointing that they couldn’t keep the unemployment rate from rising. It appears that firms have become more cautious and are unwilling to commit to hiring as many people as would be expected given business conditions. Without strong job growth, income will not increase solidly and that does not bode well for future consumer demand or business activity. Maybe the Fed was on to something when they decided to see if the economic slowdown would ease the pressure on inflation.

It has been a long, hot summer. Okay, summers are never long enough, but it has been a scorcher and what goes on during this time shouldn’t be viewed as a good indicator of where the economy is going. Yes, activity has throttled back and could stay that way for the rest of the year. Yes, we are being pressured by rising costs on most goods, not just energy. But jobs are still being created and wages are rising the fastest in years. That says the economy has not crashed. And Labor Day is not here yet. So get out there and enjoy what is left of the summer and remember: spend, spend, spend. The economy is depending on it.

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 has more than $43 billion in assets. For more information about Commerce, please visit the company’s interactive financial resource center at commerceonline.com.