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Thursday September 8, 2005 - 13:42:15 GMT

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Where next for the Fed?

The Federal Reserve will face a difficult decision in the short term. Hurricane Katrina will create pressure for a looser monetary policy to support the economy, but will also increase pressure for higher interest rates to ensure that higher energy prices do not trigger a wider increase in inflation.

Overall, there appears little justification for an interest rate cut, especially as financial markets have not been subjected to significant downward pressure over the past two weeks, although the situation will change if there are delayed financial shocks to the system.

The Fed will need to take a cautious stance over rate increases, especially as it needs to maintain confidence within the consumer and business sectors. Overall, the most likely outcome is that the Fed is likely to increase interest rates again in September while reassuring markets that it will monitor the economy very closely and stop tightening if forthcoming data is weak. Alternatively, the Fed could decide to leave interest rates on hold and warn that it will resume tightening in November on the basis that the economy is likely to recover.

Katrina complicates Fed task

The Federal Reserve will face a difficult decision on interest rates following hurricane Katrina and their decisions over the next 2-3 months will have important implications for the economy and currency markets. The next scheduled Federal Reserve interest-rate setting meeting is due on September 20th, although the Fed can call an extraordinary meeting at any time if it is deemed necessary. The lack of financial-market panic makes this look very unlikely at this stage.

Growth liable to slow

Ahead of hurricane Katrina, the data suggested that the US economy was still performing relatively well, especially in the services sector, with the ISM services index rising to 65.0 in August from 60.5 the previous month. There was also a comfortable increase in employment of close to 170,000 in August after a revised increase of over 240,000 in July. There were, however, some concerns over the manufacturing sector with the national ISM index for the manufacturing sector dropping to 53.6 in August from 56.6 the previous month while there was a sharp regional drop in the Chicago regional index. There was also further uncertainty over the impact of high oil prices with some evidence that consumer spending was slowing.

The inflation data suggested that there were some inflationary pressures within the economy, but that underlying inflation was still under reasonable control. The core annual inflation rate was 2.1% in August despite sharp rises in headline inflation. Ahead of Katrina, it was reasonable to suggest that the Fed could push interest rates to 4.0% before pausing the monetary tightening.

Inflation and growth shocks

The hurricane has already caused serious economic disruption to a significant proportion of the economy and there will be a further impact over the next few months. The difficulty for the Fed is that the hurricane damage will tend to act in contradictory directions, at least in the short term. There will be a short-term drop in economic activity as a shock to the economy. High energy prices will also tend to have an adverse impact on confidence and demand, especially with energy prices already at high levels. The Congressional Budget Office (CBO) has warned that the cost could be at least US$400bn and will cut GDP growth by around 1.0%.

There will, however, also be an inflation shock to the economy as energy prices rise. The storm damaged energy infrastructure and this will keep gasoline prices at elevated levels over the next few weeks at least even if prices moderate further from the highs seen immediately after the storm. There will also be supply disruptions to the economy resulting from transport delays and shortages which will tend to increase wider inflationary pressure. Food prices are also liable to rise in the short term.

In the medium-term, there will also be an expansionary impact on the economy as there will need to be substantial construction and re-building activity. Congressional spending will rise and the overall boost could eventually be in the region of US$200bn.

Fed looking at medium term.

The Fed will be tempted to loosen monetary policy in response to weaker growth. It will, however, need to be vigilant over inflation and will also face pressure to tighten policy to prevent secondary inflation developing from the initial impact of high oil prices. The Fed is particularly keen to avoid the mistakes seen previously when policy was too loose after previous oil shocks and this allowed inflation to rise. A relaxation of policy would also tend to take effect when the economy was already recovering from the initial shock and this would risk a rise in inflationary pressure. There is likely to be great caution in cutting rates.

The initial comments from officials suggested that the Fed would prefer to maintain a tightening bias in the short term. The Fed will be able to assess the confidence and inflation indicators over the next 10 days ahead of the FOMC meeting.


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