News & Commentary

IMPACT OF HURRICANE KATRINA ON THE ECONOMY AND FEDERAL RESERVE POLICY

The devastating Hurricane Katrina, which came onshore the Gulf Coast on August 29, has brought new uncertainties to the near-term economic outlook. Although supply shocks caused by labor strikes or natural disasters can be extremely severe, as in the case of Hurricane Katrina, it is important to keep in mind that the negative impact on economic activity is typically short-lived. Similarly, the post-Hurricane surge in gasoline prices to a record of $3.50 per gallon, reflecting temporary shutdowns in hurricane-damaged refineries, should also be eventually reversed as damaged refinery capacity is brought back on line. More importantly, the ending of a strike or the recovery from a natural disaster will boost output and employment as the economy rebounds.

 ECONOMIC OUTLOOK
To be sure, the negative impact on energy production, trade, transportation and overall economic activity particularly in the Gulf Coast region, from the catastrophic Hurricane Katrina will likely depress growth in the third and fourth quarters of this year. My best estimate in that the hurricane-induced surge in energy prices will reduce third-quarter real GDP growth to perhaps 3.5% from the consensus estimate of 4.0%. In the fourth quarter, the spurt in energy prices could reduce real GDP growth from my already lower estimate of 3.3% to perhaps 2.5%. This is because post-Hurricane surge in energy prices, on top of earlier already sharp energy price increases, acts like a tax increase on consumers, thereby curtailing consumer spending, and serves to squeeze business profit margins, thereby limiting business capital spending. Serving to signal a near-term slowing in economic growth is a recently weak and erratic stock market. Moreover, the yield on the 10-year Treasury note, a benchmark for longer-term interest rates, has plunged to a post-Hurricane level of 4.07% from 4.40% in early August, reflecting investor expectations of a slowing in economic growth, as well as their low and well-anchored longer-term inflation expectations.

Nevertheless, the recovery from Hurricane Katrina should boost growth early next year as construction spending and employment boom. The Gulf Coast region will benefit from heavy government relief expenditures and new private residential and commercial real estate investment. Also there should be some easing in energy prices in 2006 as demand weakens and supply increases.

 INFLATION OUTLOOK
The near-doubling of oil prices - - to $70 per barrel in the last 24 months - - has had surprisingly little impact on core consumer prices. This is mainly because global competition has helped keep inflation in check. For example, while energy prices have been soaring, prices of imported goods from the Pacific Rim, which account for one-third of all U.S. imports, have fallen by 0.2% since December 2003. Cheaper imported goods are replacing American goods or forcing U.S. manufacturers to hold down their prices.

Moreover, a surge in the global labor supply from Eastern Europe and Asia - - including notably India and China - - during the past decade has helped keep wages under control. Also helping to keep U.S. labor costs contained has been strong productivity growth, though its pace has recently lessened somewhat.

FEDERAL RESERVE POLICY PROSPECTS
As a rule, Fed policymakers are unlikely to adjust their monetary policy stance when negative supply shocks from strikes or natural disasters are likely to be temporary and invariably followed by a rebound in output and employment. However, in the case of Hurricane Katrina, additional uncertainties have been created as the surge in energy prices comes on top of an already steep climb this year, threatening to curtail spending. Moreover, the timing of any rebound, especially in New Orleans, is in question.

In my view, these new uncertainties mean that the Fed will be more careful not to overshoot in its shift from an accommodative to a neutral policy stance. Conceivably, in view of Hurricane-related uncertainties, Fed officials may pause at their Sept 20 and November 1 FOMC meetings. Then, at their final December 13 FOMC meeting this year, Fed authorities may hike their funds rate target by another 25 basis points to 3.75%, depending on incoming economic data. One final Fed 25 basis point funds rate hike to 4.0% is possible early next year, perhaps at its January 31 – February 1 FOMC meeting, again depending on emerging economic conditions.


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