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Fed likely to hike rates despite Katrina

Faced with soaring fuel costs that could spur widespread price increases, central bankers appear likely to raise short-term interest rates again Tuesday, but Hurricane Katrina has injected a note of doubt. By Martin Wolk
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Hurricane Katrina's impact on the national economy has injected a note of uncertainty into Tuesday's meeting of Federal Reserve policy-makers, but most analysts still expect central bankers to raise short-term interest rates another quarter-percentage point.

Forecasters are betting Fed Chairman Alan Greenspan and his colleagues will be more worried about the potential inflationary impact of the higher energy prices left in Katrina's wake than about any resulting economic slowdown. The Fed is expected to announce its decision around 2:15 p.m. ET Tuesday.

"We suspect the FOMC will say that while Katrina had a devastating regional impact, aggregate growth should be only temporarily damped," Action Economics managing director Kim Rupert said in a note, referring to the policy-setting Federal Open Market Committee.

Still, there is a lingering minority view that the Fed will take the economic uncertainty introduced by Katrina as reason to pause in its 15-month-old rate-hike campaign.

"Never in the past has the Fed raised interest rates immediately after such a devastating event," Merrill Lynch economist Sheryl King said in a note. However, she added that a rate hike appears likely. Fed officials have given no public indication that they plan to take a pause, she noted, and recent comments from committee members have continued to focus on inflation.

The Greenspan Fed has been raising rates in steady quarter-point increments, pushing up the benchmark overnight rate to its current 3.5 percent from 1 percent in mid-2004. Prior to Katrina, analysts and traders almost universally expected another quarter-point hike as the Fed moves toward an undefined "neutral rate" that is presumed to be at least 4 percent.

After the scope of Katrina's devastation became clear, and energy prices soared on futures markets, many traders began betting that the Fed would move to the sidelines and leave rates unchanged. But when Fed officials failed to give any hint that they were worried about an economic slowdown, most analysts and traders moved back to the view that another rate hike is imminent.

Even though oil prices surged Monday sending stock prices down sharply, bond traders stuck to the position that central bankers will nudge rates up Tuesday as they have at their past 10 consecutive meetings.

Futures traders who make or lose money by predicting rate moves assign a 96 percent probability to the Fed raising rates a quarter-point Tuesday, according to Tony Crescenzi of Miller, Tabak & Co. That is down from a 100 percent probability before Katrina hit, but up from a low of 50 percent immediately after the storm hit, he said.

"I think they will tighten, but there is a much higher level of uncertainty regarding this decision than at any one since they started over a year ago," said Mark Zandi, chief economist for, a forecasting firm.

"The logic I think is straightforward," he said. "The economy was very strong prior to Katrina. Even with Katrina growth will stay at or above the economy's long-term potential."

Zandi also pointed out that when Fed officials next meet Nov. 1 they will be facing data showing the full force of Katrina, which is likely to send unemployment sharply higher and industrial output lower.

"It may very difficult for them to tighten" in November, Zandi said.

So far the Fed has gotten only an early glimpse at data showing how the storm is affecting the national economy.

Consumer sentiment took its biggest one-month plunge in 25 years, University of Michigan researchers reported Friday, reflecting anxiety over high energy prices and other fallout from the storm. But gas prices already have dropped sharply from post-storm peaks, and falling sentiment does not necessarily translate to lower consumer spending.

New claims for unemployment already have surged and likely will go higher, the Labor Department said this week.  Industrial production was lower than expected in August because Katrina disrupted refining activities, chemical manufacturing and oil and gas extraction from the Gulf at the end of the month, the Fed said in a monthly report. September production no doubt will be curtailed further.

“If I were still there I would be arguing … they ought to pause and not do anything and just see where it goes,” former Dallas Fed President Robert McTeer said in an interview last week.

McTeer, now chancellor of the Texas A&M University system, noted that the Fed already has hiked the overnight bank lending rate to 3.5 percent from 1 percent in mid-2004. “I don’t see any harm in letting the economy digest that and seeing where it goes,” he said.

McTeer was well-known as an inflation “dove” who generally favored lower rates in his time at the Dallas Fed, which included a rotating seat as a voting member of the policy-making Federal Open Market Committee from 1991 through 2004.

Current Fed policy-makers have been circumspect.

“In addition to the potential negative effect on growth, rising oil prices, like other unfavorable cost shocks, can also feed through and raise underlying core inflation,” Chicago Fed President Michael Moskow said in a speech last week. “So there is also a risk on the inflation front, and the risk is higher now than it was a year ago.”

“They probably will raise rates,” said Mary Ann Hurley, a bond trader at D.A. Davidson & Co. in Seattle. “But given the fact that we don’t know how Katrina is going to affect the economy, they would be very prudent to wait.”

She said Fed officials probably will raise rates in part to avoid a negative reaction from investors, who might read a pause as a signal that an economic slowdown is imminent.

“The other thing that could be the tipping point is going to be their concern for the housing sector,” she said. “They are not going to want to do anything that adds to the froth in the housing market.”

While the Fed has hiked short-term rates steadily since June 2004 and signaled its intention to continue raising them at a “measured” pace, long-term mortgage rates have held steady, buoying the red-hot housing market. The current average 30-year rate of 5.74 percent actually is below the 6.29 percent level of mid-2004, according to mortgage giant Freddie Mac.

If anything, the destruction wrought by Katrina is likely to increase demand for housing, especially as massive federal aid and private insurance money flows into the Gulf Coast region next year.