(Corrects odds of September fed funds rate increase in fourth paragraph to 70 percent. Caroline Baum, author of ``Just What I Said,'' is a columnist for Bloomberg News. The opinions expressed are her own.)

Sept. 6 (Bloomberg) -- Before Hurricane Katrina slammed into the coast of Louisiana, destroying homes, businesses and energy infrastructure and displacing 1 million people, financial markets were expecting the Federal Reserve to boost its benchmark rate to 4.25 percent by early next year.

No longer. And the Sept. 20 meeting is up for grabs.

With breathtaking speed, financial futures markets clipped as much as 40 basis points off the anticipated path for overnight rates. And that was in one short week. The March 2006 Eurodollar futures contract has rallied 50 basis points in the last month.

The October fed funds futures contract, at an implied yield of 3.675 percent, puts the odds of a September rate increase at 70 percent, compared with 100 percent at the start of last week.

Whether influenced by the markets or events, economists are changing their forecasts as well, arguing for a pause in the tightening cycle until policy makers can sort out the extent of long-term damage from Katrina.

Will the Fed's response mirror the market's expectation, which has turned on a dime in the wake of Katrina's devastation?

The answer isn't just a question of policy. Politics may be involved as well.

The Fed is an independent government entity that is charged with the conduct of monetary policy, accountable to Congress and self-financed with the profits from its huge securities portfolio. The surplus after operating expenses is turned over to the Treasury at the end of each year.

Image

That doesn't mean the Fed is immune to political pressure or free from image constraints. During his 18-year term as Fed chairman, Alan Greenspan has demonstrated his political instincts, cut deals and given his imprimatur to fiscal policies (tax increases under President Bill Clinton; tax cuts under President George W. Bush). In at least one instance, in 1990, he held monetary policy hostage to fiscal policy, promising President George H.W. Bush a rate cut in exchange for a deficit- reduction agreement in 1990 -- and delivering on his pledge.

Hurricane Katrina qualifies as a supply shock, which reduces output and raises prices. Whether the rise in relative prices -- in this case, not only energy products but also agricultural and industrial materials that move through the port of New Orleans -- is inflationary is always and everywhere the province of the central bank.

Politically Correct

If Fed officials thought monetary policy was accommodative before Katrina, and we know from the minutes of the Aug. 20 meeting they did, by all rights they should not depart from their chosen course of removing that accommodation. A portion of the nation's productive capacity has just been damaged, disabled or destroyed, so pumping up demand for reduced supply is not exactly the correct policy prescription.

But this isn't just about policy. It has a lot to do with appearances.

How would the average citizen react to news on Sept. 20 that the Fed had just tightened credit again when television screens are showing thousands of people who have no homes, no means of support and inadequate food, water and medical care? (Yes, I know the Fed is removing the policy accommodation, not tightening credit. That's splitting hairs for a public that applies the duck test: If it looks like a rate increase, it's a rate increase.)

Besides, inflation expectations, the Fed notes often, are well contained. Long-term rates have fallen in conjunction with fed funds rate expectations, suggesting confidence in the Fed's inflation-fighting credentials.

Risk Management Approach

There's no harm in taking a pass at the Sept. 20 meeting. It would be in keeping with Mr. Risk Management's approach to address what he sees as the greater threat, weaker growth rather than higher inflation.

When our regular cast of central bankers convened last on Aug. 9, it was on the heels of strong June and July economic data. Policy makers agreed that the funds rate, which was raised to 3.5 percent, was still below the level that ``would prove necessary to contain inflation pressures and keep output near potential,'' necessitating further policy action.

The Fed staff predicted that the output gap, the difference between what the economy is capable of producing and what it is producing, would be closed by year-end.

One member mentioned sluggish growth of the money supply as a sign policy might not be accommodative. (No one has heard from him since.)

Leading Katrina

In uncharacteristic fashion, Greenspan dismissed the message from the narrowing spread between short- and long-term rates at his July monetary policy testimony. The yield curve's ``efficacy as a forecasting tool has diminished very dramatically'' and the quality of its signal has declined, Greenspan told the Senate Banking Committee on July 21.

That's odd. Last time I looked, the yield curve inverted in 2000, accurately foretelling the 2001 recession. It did yeoman's work in 1989 in advance of the 1990-91 recession. And the Conference Board, keeper of the Index of Leading Economic Indicators, found its signal potent enough to retain the spread between the fed funds rate and 10-year Treasury note yield as one of 10 key components when it retooled the LEI earlier this year. (The Conference Board changed the way the spread contributes to the index from the change to the level.)

Greenspan may think the spread is meaningless as an indicator of the thrust of policy, but intuitively he trusts market signals.

In late June, I wrote that the Fed would not invert the yield curve from the front end, meaning it would not push short rates above plummeting long rates.

I still think that. The LEI was telegraphing a marked slowing in economic activity before Katrina was even a blot on the radar screen.

The Fed, with the blessing of the bond market, may hold off on another rate increase in September because of the uncertainty surrounding the effects of Hurricane Katrina.

What the Fed does for political reasons now may turn out to be the right policy prescription down the road.

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.

Last Updated: September 6, 2005 10:49 EDT