Will the Fed shrug off Katrina?

[notiCIas]

Will the Fed shrug off Katrina?

Most economists expect a rate hike Tuesday but after the hurricane, some think the Fed should pause.

September 15, 2005: 1:01 PM EDT
By Paul R. La Monica, CNN/Money senior writer


NEW YORK (CNN/Money) – Will they or won't they? Pause. The Federal Reserve, that is.

Alan Greenspan and his merry band of Fed policy-makers meet Tuesday to decide whether to raise interest rates for the 11th consecutive time since June 2004.

Before Hurricane Katrina hit the Gulf Coast, it was considered all but certain that the Fed would boost rates another quarter of a percentage point on Tuesday. But now, it's not a foregone conclusion as some worry that Katrina could hurt economic growth in the short run.

According to futures contracts on the Chicago Board of Trade, investors are betting there's an 84 percent chance the central bank will raise its target for the federal funds rate, an overnight bank lending rate that is the Fed's main tool for manipulating monetary policy. In the weeks before each of the last few Fed meetings, traders were betting that rate hikes were a lock.

"The Fed is really in a tough predicament," said John Lynch, chief market analyst with Evergreen Investments. "If they don't raise rates, the market could fear that things are worse than expected from Katrina, and if they do raise they give the perception to some of being a callous organization."

To pause...
The fed funds rate is now 3.5 percent, the highest in four years but still below historical norms.

And even though the central bank indicated at its last meeting in August that it would probably keep raising rates at "a pace that is likely to be measured," some economists and market strategists are hoping the Fed will pause in order to get more information about how much of an impact Katrina will have on the economy.

"Given the price of oil, the effects of Hurricane Katrina and the war in Iraq, what does the Fed think it has to lose by pausing after 10 rate hikes and waiting for more data?" said Michael Farr, president and chief investment officer with Farr, Miller & Washington, an investment firm in Washington. "The Fed should pause rather than run the risk of sending the economy into recession."

Farr points to the relatively small spread between short-term and long-term Treasury bond rates as a cause for concern. Despite the increases in the federal funds rate to 3.5 percent, the yield on the 10-year Treasury is still a surprisingly low 4.2 percent, below where it was when the Fed started raising short-term rates 15 months ago.

Relatively low long-term rates have helped keep the housing market, and the overall economy, humming. But if the Fed raises short-term rates much more, the spread could narrow further, or the so-called yield curve could even invert, pushing short-term rates higher than long-term rates. That phenomenon has typically been a predictor of a recession.

"Will the Fed keep raising rates until the yield curve's inverted? There's not much margin for error here," said Farr.

Lynch agreed, saying that the prudent thing for the Fed to do is to take a break since economic numbers for the next few months are likely to point to slower growth, at least in the short-term.

"The Fed could sit tight this month and reassess things. We certainly expect employment and production to be hit in the next 30 to 60 days," said Lynch.

Bolstering the case for a pause is the fact that inflation, despite high energy prices, appears to be relatively benign. The Fed has been raising rates in a bid to ward off inflation. But wholesale prices, excluding food and energy, were flat in August while the so-called "core" consumer price index, released this morning, rose just 0.1 percent last month.

...or not to pause
But those numbers were pre-Katrina. Some economists believe that the disruption in oil drilling in the Gulf of Mexico as well as the closure of key ports in the region will lead to higher prices for a variety of goods.

"Inflation risks continue to outweigh potential economic slowdown risks," said Ken Kim, an economist at Stone & McCarthy Research Associates, an economic and bond research firm in Princeton, N.J. "If crude oil prices remain where they are we will certainly see some pass-through of higher energy costs from producers to consumers."

As such, Kim believes that the Fed will and should raise rates another quarter point.

Economists say the Fed also needs to consider how much of an impact the rebuilding of New Orleans and other cities and towns in Louisiana and Mississippi will have on the economy -- and inflation.

"Higher oil prices and the stimulus coming from additional spending after Katrina both suggest that Fed would be on the side of raising rates," said Oscar Gonzalez at John Hancock Financial Services. He estimated that as much as $100 billion could be spent on reconstruction.

With that in mind, he also believes that the Fed will raise rates on Tuesday

Steve Van Order, chief bond strategist at Calvert Funds, also thinks the Fed should stick to its "measured" rate hikes. So in addition to raising rates Tuesday, he believes the central bank will telegraph another probable hike at its Nov. 1 meeting.

Van Order said that since the Fed has done a good job of tipping its hand to investors for the past year, a deviation from its plan could be more unsettling to the economy, and financial markets.

What's more, he said, if the Fed pauses in September and then sees inflation heat up, it may be forced to raise rates more aggressively later on.

"If the Fed pauses, they may have to catch up down the road. I think they want to avoid that," he said. "The Fed wants to fight inflation. That's their main goal and objective."

Stone & McCarthy's Kim added that a pause next week would be a bad move because then the market would have no idea what to expect in November. "If the Fed deviates they inject uncertainty back into the market. There would be a whole host of questions," he said.

But Farr, who thinks the Fed will raise rates on Tuesday, is worried that the banker's focus on inflation will be more detrimental than any jitters that would arise from a Fed pause.

"Greenspan has been like a dog with a bone, very tenacious," Farr said. "I think the Fed will make a mistake. They will go too far. They always go too far."