An Economic Storm Surge

The Fed, hiking rates, underplays the economic cost of Katrina

What will be the net impact of Hurricane Katrina on the economy? That question is trickier than it seems. The terror attacks of September 11 did less long-term economic damage than first predicted, in part because the Federal Reserve was induced to keep interest rates very low for nearly three years. But in Katrina's case, the opposite could happen. Katrina's direct and indirect economic costs are likely to be underestimated, and the Fed is compounding the damage by hiking rates.

Katrina brought an added jolt to energy prices that were already rising due to tight supplies of natural gas and oil products and heated demand from China and India. With oil refineries running at more than 96% of capacity, it didn't take much damage to cause gasoline price spikes that will last for months. But consumers also will soon face home heating and electricity bills at least one-third higher than last year's. And that's on top of stubbornly high fuel prices that hit not just private autos but trucks, buses, and airlines. With three-fourths of all goods moved by truck or plane, higher fuel costs will cycle into higher consumer prices across the board.

Additional indirect costs will include insurance industry losses and higher property insurance rates, a run on some building materials, and higher shipping costs for agricultural products that normally use the Mississippi River and the now ruined Port of New Orleans. All these higher prices will function like a tax on purchasing power.

UNFORTUNATELY, THE FED is not behaving as wisely as it did after September 11. Then, central bankers erred on the side of cheap money, keeping short-term interest rates at 50-year lows and flooding the system with liquidity. Even so, the average person didn't benefit much from the resulting recovery. Real median earnings of nonsupervisory workers are where they were four years ago.

Today's economy is not all that robust to begin with. But this time, the Fed has wrongly ruled in favor of tight money. Why aren't Greenspan & Co. cutting the economy some slack? Apparently the rush of new federal spending on Katrina relief and recovery has alarmed the central bankers. So instead of cueing an end to their recent trend of relentless rate hikes, Fed governors evidently reasoned that all this added fiscal stimulus required an offsetting rate hike. On Sept. 20, with New Orleans still under water, the Open Market Committee ordered yet another quarter-point rate hike -- the 11th in a row, raising the federal funds rate to 3.75%.

Yet here is a case where inflation statistics are entirely misleading as economic indicators. The consumer price index will likely rise in coming months, as higher energy, transportation, and borrowing costs work their way through the economy. But these price increases are signs of economic weakness, not the type of overheating that sometimes justifies higher rates. The result of this misguided inflation vigilance: The Fed is leaning against growth, just as growth is faltering due to the hurricane's big hit to purchasing power.

At a deeper level, Katrina increases the stress on the core weakness of the American economy -- its ever-greater reliance on foreign borrowing. The U.S. has a dangerous and escalating co-dependency with Asia, most notably China and Japan. They keep lending us dollars to cover our huge trade imbalances and our absence of net domestic savings. We keep using those dollars to keep buying their products. No serious observer thinks this game can go on forever. It's only a question of what event triggers a break, and perhaps a dollar crash. Katrina, whose short-term recovery costs will increase the federal deficit by at least $200 billion and cause America to borrow even more from abroad, intensifies the strain.

Not one of these problems has a short-term cure. True energy independence is a long-term project, which the Bush Administration is failing to take seriously. Restoring fiscal balance will take time and political leadership, yet the Administration is persisting with its program of tax cuts -- worsening deficits. Reversing the structural trade imbalance and its huge foreign borrowing could be partly achieved by better fiscal policies, partly by more symmetrical trade rules. But little progress is in sight. Protecting our cities from the escalating risk of global warming and flooding will require a shift in energy consumption policies as well as large outlays for public infrastructure. Here again, there's little awareness at the White House, and less leadership.

For now, the economic costs of Katrina are a slow drip. If markets get panicky -- and they have reason to -- the costs could turn into a major flood.

Robert Kuttner is co-editor of The American Prospect and author of Everything for Sale

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