By Michael Englund The damage from Hurricane Katrina is still being tallied, but we at Action Economics have decided to take a first pass at gauging how wide a swath the storm will cut through U.S. economic output. In total, we're assuming it will subtract 0.7 percentage points from growth in gross domestic product in the third quarter, lowering the expected U.S. growth rate to 3.7%. We expect an additional 0.4 percentage point hit to the fourth quarter, with growth in that quarter now set at 3.9%. However, we forecast positive effects of 0.2 to 0.5 percentage points in each of the four quarters of 2006.
While most hurricanes have economic effects, Katrina has at least three unique factors: its impact on U.S. energy production; the related devastation of a major urban center, New Orleans; and the disruption of a vital transportation artery, the Mississippi River. Absent those factors, we might have expected a GDP subtraction of 0.3 percentage points from the third quarter, but a 0.1 percentage point positive impact in the fourth, as well as the four quarters of 2006 on average.
But Katrina wasn't your ordinary hurricane. It struck a critical region for the national oil industry in terms of production, importing, and refining of petroleum products. Such strategic dependence on a specific region hit by a storm was absent in prior hurricanes in Florida, the East Coast, and Hawaii. Damage assessments are ongoing, and it will be some time before the overall impact becomes clear.
DELAYED RECOVERY. As it stands, we're assuming that the disruption to the region's energy industry subtracts roughly 0.2 percentage points from the third quarter and 0.3 percentage points from the fourth beyond the prior estimate of usual hurricane effects. However, we think the energy impact may add 0.1 percentage points to each quarter of 2006, as the price effects linger from ongoing lean hydrocarbon stockpiles, as refineries will have difficulty raising inventories of most petroleum products back to normal levels relative to crude oil costs.
The negative effect of the oil shock largely comes from the income drain from higher energy prices for purchase of nonenergy goods, as well as reduced "real" (adjusted for inflation) purchases of energy goods. However, reduced oil imports will actually have a partially offsetting positive GDP effect.
The second unique Katrina effect was the complete loss of infrastructure -- water, electricity, transportation, telecommunications, etc. -- in a major city. With other hurricanes, a large part of the infrastructure in all the damaged areas remained intact. In the case of New Orleans, many repairs will occur in sequence rather than in parallel. This is because the evacuation of the city, and the associated flooding, will delay the normal recovery time.
Some observers now suggest that six months will pass before large parts of the city can be repopulated, though some also believe that parts of the city may be reentered relatively soon.
4Q CARRYOVER. A countervailing factor is that insurance payments to those with coverage will be sizable, as many payouts will be at the maximum coverage level, and many will take advantage of insurance-paid rent for comparable housing that can last for two years, depending on the policy. Reports indicate that vacancies have virtually disappeared in many Louisiana markets, and we expect significant rental market tightening throughout a broader region that will ultimately have impacts nationwide.
In addition, many large companies are offering open relocation policies to employees, with Wal-Mart's (WMT) recent announcement of such a plan providing just one visible example. As such, we can't simply subtract the GDP of New Orleans from the national total, or the number of employees from payrolls, to produce estimates. In addition, the spending of those with insurance coverage will surge substantially from normal levels starting almost immediately.
As of now, at Action Economics we're assuming that the New Orleans effect will account for only a 0.1 percentage point additional subtraction from third-quarter GDP, as much of this immediate dislocation is captured by the "usual" disruption effect derived from the aggregate damage estimate of prior hurricanes. But a larger 0.3 percentage point subtraction is assumed in the fourth quarter, when negative effects in prior hurricanes would have dissipated.
Then, for the first three quarters of 2006, there should actually be a sizable positive effect on GDP, as the rebuilding will be a massive national effort rippling through all the construction, equipment, service, and industrial supply industries, leaving additions to economic output of perhaps 0.1 percentage points to 0.2 percentage points per quarter for all of 2006.
A FED PAUSE? Finally, let's look at one other negative impact specific to Katrina: disruption of shipping on the Mississippi River. Here, we're preliminarily assuming that a rapid recovery is under way, and the expectation is that backlogs will ease and shipping will regain much of its strength as the summer crops from the Midwest -- the dominant export traffic through the region -- come to market. If this proves true, we may subtract only 0.1 percentage points from third-quarter GDP and add 0.1 percentage points to the fourth.
Of course, while all eyes are on the Gulf region and its recovery, a separate event is under way that would otherwise command market attention: the Boeing (BA) machinist strike. Boeing will cease shipping aircraft during the strike, and the result is that we will see a subtraction of 0.2 percentage points from third-quarter GDP if the strike continues through the end of September. For our GDP estimates, we will assume that shipping resumes in the fourth quarter, with a complete production recovery during the quarter.
In addition to the impact on economic growth, the markets have been eager to anticipate Katrina's effect on Federal Reserve policy. We now expect the Fed to pause in its ongoing series of rate hikes after quarter-percentage-point tightenings at its next two meetings in September and November, leaving the Fed funds target rate at 4% in November. (Previously, we had expected policymakers to pause in February, 2006, after hiking rates to 4.5%.) This will remove much of the upward pressure on long-term interest rates over the coming six months.
One final note: It's worth remembering that prospects for U.S. GDP growth were quite encouraging before Katrina, and our forecasts for the third and fourth quarters previously sat well above most market estimates. Of course, our GDP estimates will remain quite sensitive over the days and weeks ahead to emerging damage and repair estimates, as well as political decisions on spending plans.
Englund is chief economist for Action Economics