Fed likely to hike rates despite Katrina

Martin Wolk Chief economics correspondent • Profile • E-mail

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 Economy.com, 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.

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