COMMERCE BANK ECONOMIC REVIEW - SEPTEMBER 2007

“The risks to the economy continue to grow.”

By Joel L. Naroff, Ph.D.

It was not a great month. The subprime problem blossomed into a full-fledged credit tightening and the labor market took a turn for the worse. Can the economy survive this dual blow? Good question.

What happened? Basically, growing default rates in the subprime mortgage market finally caused people to take off their rose-colored glasses and start looking seriously at the risks they were taking. What they saw they didn’t like – to say the least. The financial assets they thought were of real value suddenly became really risky. Mortgage companies began to fold. It was time to face reality.

Unfortunately, when fear strikes, the financial markets react swiftly and strongly. If you don’t really know what the risks are, firms assume the best thing to do is to withdraw from that market, which is what happened. The subprime lending market largely disappeared. Interest rates on mortgages, if they even could be had, rose sharply for anything that was not a plain vanilla loan. 

The housing market, which had already been reeling, now faced a new challenge: How to regain its footing in the face of dwindling mortgage lending. With sales weak and record inventories of homes waiting to be sold, the outlook took a turn for the worse.

But it was not just housing that was hit by the sudden tightening of credit standards. Corporate capital markets were affected as well. There was a generalized repricing of risk and that meant that interest rates on loans were rising and some types of loans were no longer being made.

As the credit crunch deepened, central banks around the world took action. The Federal Reserve lowered the discount rate and encouraged banks that needed money to borrow from it. This stabilized the system, although the tight credit standards and limited funding remains.

On top of this, we got the August jobs report. For the first time in four years, there was actually a drop in payrolls. The June and July job gains were lowered as well. This seemed to indicate that the economy was headed in the wrong direction or was hardly growing at all.

So, with all this terrible news, should we assume a recession is right around the corner?  Not necessarily. The nation’s purchasing managers told us that the economy continued to grow at a decent pace during August. Small business remained reasonably upbeat about their situation. And firms continued to expand their sales to the rest of the world. It is hard to say a recession is at hand if most groups at the forefront of the economy tell us it is not.

So where do we go from here? Clearly, the credit crunch has raised significantly the risks of a recession. Yet job growth could bounce back, although if it does not, it would be hard to argue that a major slowdown was not in the works. The potential savior is the Fed, which is expected to cut rates – with additional reductions over the rest of the year likely. That might not ensure an economic rebound, although it could help stave off a downturn. Still, it is nail biting time and the room to maneuver has shrunk. 

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 450 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 $48 billion in assets. For more information about Commerce, please visit the company’s interactive financial resource center at commerceonline.com.