COMMERCE BANK ECONOMIC REVIEW - February 2007

 “The deep freeze and too much spending raise some questions about future growth.”

By Joel L. Naroff, Ph.D.

No good weather goes unpunished. The unseasonably warm December and early January temperatures meant we didn’t have to heat our homes too much. But that has changed, and we are now directly depositing our pay into the utility companies’ bank accounts. Business activity continues to hum along, but whether that strong growth can be maintained is a real question.

The economy blasted out of 2006. GDP growth accelerated to 3.5% at the end of last year, well above what anyone had forecasted. Consumers led the way. But it wasn’t just households doing their patriotic duty and spending like maniacs. We sold tons of “Made in America” products overseas. The trade deficit narrowed sharply, adding tremendously to the expansion. The Bureau of Economic Analysis finally discovered the Iraq War and defense spending surged. 

On the other hand, there were some weak sectors. Residential construction continued to decline at a massive pace. Housing should start stabilizing during the first half of the year, reducing the sector’s negative impact. But don’t expect a major turnaround anytime soon. Businesses investment, a major stalwart of the economy, tailed off. That could signal that business leaders are becoming more cautious. And as usual, there was a weird number in the report. If you believe the government’s data, the politicians in Washington found financial religion and domestic spending tanked. Yeah, right! 

The devil is always in the details and there was one number that shouts ‘watch out’. The savings rate in 2006 was a negative 1%, the lowest since 1933. Although economists may argue about the validity of the rate, since it does not consider changes in home values or stocks, it still tells us about households’ spending habits. And they are spending everything they make and more. 

Rising equity and house prices made us feel wealthier. But for many people, the lack of savings needs to be reversed and when that happens, spending and the economy could slow. When you add the softer increase in payrolls we saw in January, raising the caution flag – at least a little bit – makes sense.

Meanwhile, back at the Fed, the future looked bright – and that worries me. The rate-setting FOMC met and, as expected, did nothing. But the statement seemed almost giddy: Inflation was easing, growth was firming and even the housing market was stabilizing.  On that last point, it seems that the Fed members and the major developers are living on different planets. Most builders are saying they still don’t see any bottom to the housing market. 

So where are interest rates going? The cold weather put the brakes on the decline in energy costs and oil prices jumped over the past few weeks. Productivity is easing, making it more difficult for firms to absorb rising labor costs. Thus, it is unclear how much inflation will moderate even given the possibility of softer growth. 

When you put it all together, you realize the inflation puzzle pieces are not all there. The Fed will have to wait awhile before the tussle between growth and inflation has a more definitive winner. I still think the next move is a rate cut, but we might not see that before the summer. 

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 more than 430 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 $45 billion in assets. For more information about Commerce, please visit the company’s interactive financial resource center at commerceonline.com.