COMMERCE BANK ECONOMIC REVIEW - July 2006

Slower Growth and Higher Inflation Don’t Mix

By Joel L. Naroff, Ph.D.

Economists have a saying: If you keep forecasting something long enough, it will eventually come true. Well, we’ve been expecting the economy to throttle back for a while and it finally appears that is the case. At the same time, inflation is picking up.  Welcome to a period of slower growth and rising prices. 

The nation’s purchasing managers are at the forefront of the economy. When they are happy, that usually means the economy is in good shape. The Institute for Supply Management surveys these people and it seems that the smiles are beginning to disappear from many of their faces. Declines in the measures were found for both manufacturing and services, indicating there is broad-based moderation in growth.

The weakening in the economy is creating some caution in the corporate sector. Firms remain somewhat unwilling to hire new workers. In June, firms added a disappointing 108,000 new employees. Worse, for the last four months, job gains were at a pace you might expect to see when the economy is limping along. 

But while payroll gains are barely visible, workers seem to benefiting from the low 4.6% unemployment rate. Wage gains are picking up. Indeed, wages are now rising at a pace not seen in quite a long time. This is adding to income. However, it is not causing people to run out and visit the malls. Maybe that is because it costs so much to drive there.  Whatever the reason, retail sales have softened. 

All this negative news may seem to indicate the economy is tanking. It is not. But it is clearly slowing. For the Federal Reserve, that is good news. The Fed continues to express concerns about inflation. And they have every good reason. While rising wages may help workers, it does put pressure on business costs. Indeed, inflation continued to slowly accelerate. Rather than wait for the easing economic activity to take the pressure off of wages and prices, the monetary authorities decided that something had to be done: They increased interest rates again. 

The Fed is trying to slow growth so that inflation does not get out of hand. Of course, since the economy has already started to slow, there are worries the Fed could go too far.  While the Fed might raise rates again, if consumers and business remain cautious, it is doubtful there will be many more hikes. 

What would be nice is if Fed Chairman Bernanke indicates more clearly what he and his fellow monetary policy mavens are thinking. Right now it is not clear, and when confusion reigns, investors become unhappy. So, if you were wondering why the stock markets have bounced around so much, you now have one partial explanation. Of course, with oil prices hitting new record highs and political crises popping up all over the globe, it is quite amazing that stocks haven’t tanked. 

Looking forward, the battle between higher inflation and slower growth will continue to play out. But the economy is strong enough that a recession is hardly an issue, at least for the remainder of the year.

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 $40 billion in assets. For more information about Commerce, please visit the company’s interactive financial resource center at commerceonline.com.