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The Fed Looks Past Katrina

By Michael Wallace Federal Reserve policymakers hunkered down on Sept. 20 to decide how best to navigate the turbulent macroeconomic waters in the wake of Hurricane Katrina. In the end, the Federal Open Market Committee stayed on its "measured" policy course to reduce "accommodation" in monetary policy, courtesy of another quarter-point increase in the Fed funds target rate, to 3.75%. This marks the 11th consecutive hike of the current rate-setting cycle.

At the same time, the FOMC acknowledged that, while economic distortions from the regional disaster in the Gulf of Mexico merit deeper inspection in the near term, they don't present a long-term threat to the expansion that began four years ago. This sanguine view of Katrina's impact came even as another hurricane, Rita, entered the Gulf's warm waters.

AT A GOOD CLIP. In its post-meeting statement, the FOMC reiterated that risks to both sustainable growth and price stability were more or less balanced with this policy action, but, as usual, it vowed to respond to future changes in those prospects.

The Fed employed an extra paragraph in the Sept. 20 communiqué to justify its tightening move, despite the jump in energy prices relating to Katrina that some market participants worry will grind the economy to a halt. The Fed's take is that the economy had been moving at a good clip before the Gulf events.

It agreed that "the associated dislocation of economic activity, and the boost to energy prices imply that spending, production, and employment will be set back in the near-term." These effects may also be compounded by higher premiums on energy products, given the snags at production and refining operations in the Gulf.

STILL "MEASURED." Yet these disruptions weren't anticipated to leave a lasting mark. While they may have "increased uncertainty about near-term economic performance," in the FOMC's view, "they do not pose a more persistent threat."

The statement simultaneously flagged greater inflation risk from higher energy prices, though core inflation (which excludes food and energy prices) and longer-term inflation expectations remained in check.

Wall Street keyed on the FOMC's retention of the forward-looking phrase "policy accommodation can be removed at a pace that is likely to be measured." There had been some speculation in financial markets that either "accommodation" or "measured" could have been dropped.

CRACKED FRONT? This would have signaled that the Fed was approaching policy neutrality and a likely pause in its tightening cycle. But such speculation proved premature. In an interesting development, the Fed's unified front was cracked by the dissent of Fed Governor Mark Olson, who favored "no change" in policy at this meeting.

Olson, who prior to coming to the Fed spent most of his career at the Securities & Exchange Commission, is known for his dovish leanings (i.e., a policy focus that places a greater emphasis on fostering growth than fighting inflation).

Overall, the hike and its explanation were in line with the broad consensus of what Fed officials have said publicly in the wake of Katrina. Their "Fedspeak" had leaned toward a temporary lull in otherwise improving economic activity and a simultaneous risk of a pickup in core inflation from the damage to the U.S. energy infrastructure.

STAYING ON THE PATH. Certainly no move had been made to alter market perceptions that a hike was anything but a done deal. As the economy rebounds, Olson may yet recant his dissent. The minutes from the Sept. 20 meeting, set for release on Oct. 11, may provide more insight on his motives.

Reaction in the markets was quite mixed, with Treasury yields initially surging, paced by shorter-dated issues, as the Fed appeared to remain firmly on the tightening path.

The yield curve -- the spread between 2-year notes and 10-year notes -- flattened sharply on the statement. The dollar followed short-term rates higher, while stocks plunged on the policy outlook, despite a slump in crude oil.

COMFORTABLE PLATFORM. Prices of Fed funds futures, a trading vehicle to bet on the future direction of interest rates, indicate the market thinks policymakers have another quarter-point hike in store for November's FOMC meeting. Moreover, some market observers are already eyeing another hike in December to 4.25%.

We at Action Economics expect the Fed to carry on for another "measured" hike in November, but will pause at 4% on the Fed funds rate before resuming tightening next summer.

This will provide a comfortable platform for the next Fed chairman to take the helm and survey the policy horizon into 2006. Of course, much depends on the patterns in economic and inflation data over the next month, as the extent of the damage wrought by Katrina on the U.S. economy becomes clearer.

Wallace is global market strategist for Action Economics

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