COMMERCE BANK ECONOMIC REVIEW - March 2006

What Goes Down Can Go Back Up

By Joel L. Naroff, Ph.D.

Sir Isaac Newton wrote that what goes up, must come down. And that is generally true.  Newton didn’t know about rockets leaving the earth’s gravitational pull. Well, Newton’s Law is also generally true that when it comes to the economy. But there is another part to the rule: What goes down can go back up. That seems to be the case with economic growth as well as interest rates.

When the Bureau of Economic Analysis first took a look at the economy, it appeared that it grew by a very modest 1.1% growth pace at the end of 2005. At second glance, it now looks like we grew at a still slow, but not as sluggish, 1.6% rate. And things are getting better. Consumer spending surged in January as the warm weather brought out the desire to shop in all of us. Of course, the cold and snow of February may have turned things around a bit. Thankfully, you just can’t keep the American consumer from their favorite activity: No, not filling out the NCAA basketball brackets – shopping!

And it looks like there will be enough income for people to keep spending. Job gains in February were quite strong as businesses added 243,000 new employees. More importantly, firms are beginning to pay up for their workers. With an unemployment rate below 5%, it is getting harder to find skilled workers and as a consequence, wage gains are accelerating. Indeed, we might soon see income growing faster than inflation. That would surely help keep the economy going and take some of the burden off of so many households.

But the good news on the economic and wage side is not necessarily good news for interest rates. As wages rise, business costs increase as well, especially since productivity is slowing. The concern is that firms will start looking for ways to generate income to offset those higher labor costs and they will do that by raising prices. 

That problem with rising inflation fears is that it leads to higher interest rates. Longer-term rates, which determine 15-year and 30-year mortgage rates, are on the way up and have reached levels not seen in almost two years. In addition, the Federal Reserve is expected to raise rates again and that would lead to higher costs for things such as Adjustable Rate Mortgages. People looking to buy homes are finding that rates are no longer cheap.

As mortgage rates rise, the already softening housing market is likely to come under even greater pressure. In January, both existing and new home sales fell sharply. Price gains are slowing significantly and, with an awful lot of homes on the market, we could start seeing prices falling in many parts of the economy.

The economy had weakened, but it is now improving as consumers are spending once again. Yet Newton’s law still holds. The hot housing market is cooling and that could lead to a softening going forward. So look for ups and downs in the growth rate this 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 more than 375 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 $38 billion in assets. For more information about Commerce, please visit the company’s interactive financial resource center at commerceonline.com.