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September 17, 2005
FOMC meeting draws closer and the Katrina effect is still making people wonder
From the NY Times
With few economic reports due this week, the Federal Reserve has the stage pretty much to itself. But even if the calendar were full, it would be hard to deflect traders' attention from the first formal opportunity to gauge the Fed's thinking on interest rates and the economy since Hurricane Katrina.
Stocks have rallied since the hurricane, at least partly in the hope that the Fed's rate-setting panel will end its streak of 10 consecutive quarter-point rate increases when it meets on Tuesday. That is the expectation of Henry J. Herrmann, chief executive of Waddell & Reed, the asset management firm, but he does not think that the Fed will stand pat for long.
"They'll find some reason to go on hold and signal at the same time that the economy is continuing to do well and that just because they are passing this time doesn't mean they won't raise rates again," he said.
Ultimately, he said, repairing the damage caused by Katrina is likely to result in a new growth spurt.
"Based on everything I'm hearing about the government programs that are going to be put in place to restart New Orleans, you could make the argument that the economy is going to be hurt in the short term," Mr. Herrmann said, "but a reasonable person would conclude that there is then going to be an acceleration" in growth.
The number I'm hearing is $200 billion in anticipated federal spending. But is that meant to be disbursed all in one year? It looks like about $51 billion has been appropriated already. Certainly there will be more in the next 12 months, but how much more? It's an important question. Remember that the first appropriation for the Iraq war was around $80 billion. By now spending on Iraq is certainly in the hundreds of billions, but has been spread out over the 2 1/2 years since the beginning. Estimates of the cost of the Iraq war vary, but for sake of argument, let's call it $100 billion per year. It would seem reasonable, given the figures quoted above, that the spending appropriated for the clean up of Katrina will be at about that level as well. At least it is reasonable to expect them to be on the same order of magnitude. And yet, the spending on rebuilding after Katrina will come after a period of hurricane-induced slack in the Gulf region. This would tend to mitigate any national inflationary effect. One could reasonably argue that Katrina will be less inflationary in the long run than the Iraq war.
Yet it seems to me from what I've been hearing that the spending on Katrina is being regarded by the media and the pundits as much more inflationary than spending on Iraq. Yes, there were (and are) some who point out that the spending on Iraq could be an engine of growth and dangerous to price stability. But those voices are scarcely being heard in the din over Katrina's effect.
Now I wouldn't characterize the Iraq war as an economic growth engine, per se. It's impact on growth and inflation is small but positive. As a driver of GDP growth lately, it pales in comparison to consumer spending driven by the housing boom (or bubble, if you prefer). Why is Katrina expected to be so different?
More evidence that Katrina is expected to be different can be found at macroblog. Altig shows that in the last few years there have been two major spikes in consumer expectations of inflation. After September 11, people expected a big drop in inflation. After Katrina there was a big jump. (There was some volatility around the start of the Iraq war, but nothing as big as the other two spikes.) Furthermore, the aftermath of Katrina is causing a jump in 5 to 10 year inflation expectations that the Iraq war did not! To me, this seems a little backwards. In 5 to 10 years, Katrina will be a painful memory with the requisite spending tapering off, but the Iraq war may very well still be with us.
I will grant that it is possible that in the aftermath of Katrina a lot of economic chickens are coming home to roost. People are recognizing that Iraq and Katrina together make a powerful one-two punch to the budget. No argument there.
Even so, the reaction is hard to explain. Even harder to explain are statments like this, again from the Times article.
As is often the case when the Fed's policy makers announce their rate decisions, the accompanying statement is likely to carry more weight than the decision itself. If the Fed holds steady and hints that further increases are not necessarily in store, stock prices could benefit, Mr. Herrmann said.
Well, yes, the stock market would party like it was 1999 on that news. But if you believe what Herrmann was saying earlier about the "acceleration in growth," what others are saying about Katrina's inflationary impact, and the consumer inflation expectations both long term and short term, how do you regard it as even possible that the Fed will stop now and hint that further increases are not necessarily in store? Admittedly, Herrmann may not believe that will happen, but even mentioning it seemed like a non sequitur.
Both views (hike rates relentlessly because Katrina was a catalyst for more inflation or stop altogether becauase Katrina was a catalyst for slower growth) are clearly present out there. At least one of them is wrong. Perhaps both are wrong. In any case, we will soon get a better idea of what the FOMC thinks, and it causes me to make the only prediction that is almost 100% certain to come to pass.
On Tuesday, we will have a lot to talk about.
(My prediction that is admittedly less than 100% certain to come true still stands about the same as before--another increase, possibly with language indicating the measured pace may slow. But that last part is no sure thing.)
Posted by William Polley at September 17, 2005 9:29 PM
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