Prophets

Harvey Could Alter Fed's Inflation Calculations

The storm could make the data signals harder to read by sending growth lower and gasoline prices higher.

Flooding affects refineries, too.

Photographer: Win McNamee/Getty Images

The Federal Reserve is on the verge of implementing critical policy changes, but Hurricane Harvey could make the data signals harder to read by sending growth lower and inflation, along with gasoline prices, temporarily higher.

Before Harvey, the Fed was facing below-target inflation against the backdrop of a greatly improved labor market. The health of the labor market is likely to be reaffirmed in the August employment report issued today. Yet the report for September, which will be released on Oct. 6, could show some negative impacts from the disruption caused by the storm. The magnitude of these negative impacts will depend on how long it takes for the Houston economy to get back on its feet.

One of the most immediate and visible impacts of the hurricane has been the rise in gasoline prices. NYMEX gasoline contract prices have spiked on fundamental supply concerns, and technicals have exacerbated the upside price risks, following a significant breakout above the NYMEX gasoline Bollinger Bands. This has already started bullishly affecting retail gasoline prices. With the potential for refineries and other critical energy infrastructure to be disrupted for weeks, gasoline prices could face the risk that prices increase further over the coming month, as petroleum product supply concerns rise and weekly U.S. oil inventory reports include post-hurricane swings in the data.

The only thing that could mitigate upside risks to gasoline prices in the immediate term is the imminent end of the summer driving season. But that is unlikely to be enough to prevent high gasoline prices in coming weeks. Those could mean more inflationary pressure, though fed funds futures indicate that a rate hike in September, and even December, is unlikely.

Inflation has been low and below the Fed’s 2 percent target, and the Fed’s priority core PCE and core CPI are likely to be less affected by the rise in gasoline prices. Yet total inflationary pressures face upside risks. The most recent consumer inflation report for August showed total CPI and Core CPI up only 1.7 percent year-over-year. But that is likely to rise, especially in the September CPI report, which will be released in October.

Analysts and traders will know that gasoline prices are behind a potential near-term rise of inflation, but that does not mean they won’t trade around this risk. The dollar could find support in September, as gasoline prices remain elevated. And the greenback could find further support with the inflation reports for September. Given the U.S. currency's decline at the end of last week below a critical technical floor in place since January 2015, the surprise upside risk to inflation presented by Harvey may be one of the few forces that could slow a further decline in the dollar. But even hurricane-induced inflation is unlikely to reverse the fundamental trend of dollar weakness that has been weighing on the greenback all year.

Aside from the inflation impact of Hurricane Harvey, the huge disruption in economic activity in Houston and the U.S. Gulf Coast could adversely impact the September employment report, turning a critical data point into noise. Of course, other U.S. economy data releases could be affected as well, including trade and growth data. Any negative growth impact could make the Fed’s path less clear. The central bank is already facing a tough set of challenges, with the labor market providing a solid green light for monetary tightening, but low inflation holding back rate hikes, along with the potential for economic data to slow or stall a reduction of the Fed’s balance sheet.

Data collected in September could reverse those factors -- showing more inflation but softer growth -- but they may leave the Fed stuck with the same dilemma: Not all indicators are providing a go-ahead for tightening monetary policy. The Fed is looking for clear signals, and Harvey reduces the potential for clean economic data. And clean data could be hindered for months, as noisy data are anticipated in September, released in October, and countervailed or revised in subsequent months.

The Fed faces a monumental challenge in reducing its balance sheet -- a challenge the European Central Bank failed to surmount when it reduced its balance sheet between 2012 and 2014. As the U.S. central bank contends with mixed signals, any further lack of clarity in economic data for employment and growth could engender significant volatility in Treasuries, equities and currency markets. The storm could affect a wide range of growth data, feeding into the risk of unprecedented volatility for the Fed.

Bloomberg Prophets Professionals offering actionable insights on markets, the economy and monetary policy. Contributors may have a stake in the areas they write about.

    To contact the author of this story:
    Jason Schenker at jasonschenker@prestigeeconomics.com

    To contact the editor responsible for this story:
    Max Berley at mberley@bloomberg.net

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