COMMERCE BANK ECONOMIC REVIEW - May 2006

Has the Fed Decided to Stop Raising Rates?

By Joel L. Naroff, Ph.D.

The economy continues to hum along. Okay, some of the recent data didn’t look that great on the surface, but the reality is that businesses are doing well in spite of skyrocketing energy costs. But the really important news were signals that maybe, just maybe, the Federal Reserve could stop raising short-term interest rates. 

Although there was not a whole lot of rain in April – at least in the East – everything still seemed to have come up roses. The consumer spent a lot of money at the malls and even bought a few motor vehicles. So far, the outrageously high gasoline prices have not caused a major cut back in consumption, although that could very easily happen as these prices are showing no signs of coming down soon.

The clearest sign of how good things are came from the nation’s purchasing managers. The people who are at the forefront of the economy were almost giddy in their description of it. They indicated that both the manufacturing and service sectors accelerated over the month as orders, output and hiring were strong. 

Of course, strong growth does not come freely and inflation has begun to accelerate, but I don’t have to tell anyone that. But I am also talking about the measures that the Federal Reserve and many traders consider: Inflation excluding food and energy. While most of us would love to be able to skip buying gasoline, the rise in energy costs has begun to slip into business pricing decisions. That is a worry for all of us, including the Federal Reserve.

With all of this good news, you would think that firms would be out there hiring like crazy. They probably were, but the government – in its infinite wisdom – didn’t find that to be the case. Job gains in April were sluggish. Maybe the data don’t tell the whole story. Could it really be that all those stores reporting large increases in sales in April did it with fewer workers? Retail employment supposedly dropped sharply. And if you believe that…there is a bridge you can buy in Brooklyn or a show you can invest in on Broadway. Anyone seen Mel Brooks lately?

But the real focus over the past month has been the Fed. Yes, the rate setting committee continued their policy of coffee and a ¼ point rate hike. But Chairman Bernanke has signaled that the Fed might be ready to stop raising rates. The statement about the rate hike seemed to indicate that the monetary authorities were leaning toward not increasing rates when they meet in late June. 

Why would the Fed consider not continuing raising rates when the economy is strong and inflation may be picking up? The answer is that monetary policy works with lags and those lags have to be factored into policy decisions. It could take twelve to eighteen months before the full impacts of a rate change take effect. Having started raising rates less than two years ago, there is an awful lot of tightening still to be felt. Apparently, the Fed wants to see how the previous rate hikes affect the economy. 

Over the next month, the key data are likely to be the inflation numbers. If they don’t get too out of hand, the Fed could stop raising rates – at least for a while. 

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.