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The economic aftermath of Hurricane Katrina

Economics Weekly: Economic Research and Analysis: The economic aftermath of Hurricane Katrina

Overview
Quite a lot has already being written about the effects
of hurricane Katrina in the US, but that is because it is having an impact far beyond the area it devastated. In this paper, we summarise our view of its main impact, along with the implications for the UK.

Massive effect from Hurricane
The US hurricane has had an incredibly destructive impact on the people of Louisiana and on the southern states. Whilst the human cost cannot be measured, there are efforts to put a cost on the suffering in terms of likely economic impact. What makes this episode different of course is that oil refining capacity has been badly hit (10% of US capability) and crude oil supply has been disrupted as well (though this is rapidly coming back on stream and oil prices are lower now than before Hurricane Katrina struck), see chart A. But it is the impact on refined fuel, which will be most directly felt as it reduces disposable incomes, and on through trade via ports in Mississippi, see chart B. Crude oil prices have already fallen back on promises by the US President to use stock from the Strategic Petroleum Reserves, by some EU countries and the International Energy Agency (IEA) to do the same thing with their strategic oil reserves and by commitments from some oil producers to increase output. But the impact on the US and global economy could still be negative, as the events in the US may keep oil prices higher than otherwise. The effects of the disruption to trade through the southern ports are less certain, but there is bound to be some related negative impact. Purely based on the contribution of Louisiana to the US economy (3 to 4%), the impact of Katrina should take no more than 0.4% off growth, but as noted above due to oil and gasoline the effects will be bigger than this.

Gasoline price rises have so far this year not really passed through to impact wage inflation or core consumer price inflation much in the US, even though price inflation is rising fast enough to concern the central bank, the Federal Reserve. We estimate that the rise in gasoline prices since Hurricane Katrina will directly reduce US consumer spending by up to 2% annualised in September and October (0.5% to 1% in each month), and possibly for a further month after that (fuel imports from the EU may help mitigate this short run effect). However, gasoline prices will fall back as refining capacity is restored, this process will then boost consumer spending and economic recovery. Therefore whilst Q3 and Q4 US economic growth this year may be 0.5% - 1% (or 1% - 2% annualised) lower than otherwise, Q1 and Q2 2006 data should see this reverse as up to an estimated $50bn in private insurance and the first part of the $100bn or so of government spending in the area starts to boost economic recovery. The sectors most likely to benefit are construction, property companies, and suppliers of household goods and DIY, and related industries, and the sectors most at risk include insurance firms, leisure and hotels and catering. However, the worry is that since consumer spending has been the key driver of US economic growth in the last few years, anything which slows it down is a threat to the health of the rest of the economy.

Only with the benefit of hindsight will we be able to make a completely accurate estimate of the economic
impact of the disaster, nonetheless, we can make some educated guesses. Uncertainty about the direct and indirect effects of the hurricane could hit consumer and business confidence and so have a negative reaction on household and company spending. This raises the possibility (well flagged in the financial markets) that the US Federal Reserve could pause in its series of rate hikes designed to take them from an ultra loose stance to one more appropriate for an economy recovering rapidly will little spare capacity. These increases aim to cool economic growth and so control inflation. However, recent minutes from the last US Fed FOMC meeting, and latest US economic data do not suggest that interest rates will be left on hold or, if they are, it will not be very long.

To help estimate likely scenarios, it may be useful to look at the FOMC meetings due for the rest of 2005. There are three meetings set for later this year, 20 September, 1 November and 13 December. Should the Fed hold interest rates in September, it will almost certainly raise them in November and probably also in December, but possibly only if the increase was just 0.25%. If the rise in November were to be 0.5%, and so Fed funds rises to 4%, then the Fed may still pause in December, when the meeting is just 12 days ahead of Christmas. But the Fed may be reluctant to move from its position of gradually raising rates by % at each meeting, as this opens up the risk that it may fall behind the data and have to act more aggressively to catch up. It may not want to do this as the risk is that it scares highly indebted households who then respond by cutting spending and so weaken economic growth. This is one reason why, on balance, we look for a % rise at the September meeting - on the grounds that the Fed is looking to medium term inflation pressure and may feel that the economy is growing quickly enough to absorb the increase in interest rates, especially since construction will be giving a boost to the economy in Q4 this year and Q1 of 2006 at a time when its capacity is already stretched meeting current residential demand. (Of course, the rebuilding of the city will take years, so the effect will be spread out). Also, inflation trends in the US do seem to be worsening and the Fed may not want to wait. Chart B shows that gasoline prices (a good proxy for the impact of global energy costs) exert a big influence on total consumer price inflation and whilst the inflation rate excluding it is lower, it too is relatively high due to faster growth in the rest of the economy. Hence, the Fed remains concerned about inflation even though it is also concerned about growth.

With the US the single biggest export market for UK goods, slower growth there will have an impact on UK growth. Higher global oil prices, on our calculations, have already taken some 0.5% off UK economic growth this year and added about 0.4% to consumer price inflation in the year to July, so any sustained oil price rise will have a further negative impact.

Summary
Typically, crises like this Hurricane end in a rise in government spending and a burst of construction activity which then outweighs the initial negative economic impact. Of course, the human tragedies are ones that people may never recover from but economies do recover. This may be why the US currency is already recovering a little from its low immediately following the realisation of the full implications of Katrina, the stock market is up and financial markets are now not so sure that the Fed will leave interest rates on hold at the next FOMC meeting, due on 20 September. Our current view is that US economic growth may be reduced by 1% or 2% annualised in Q3 and Q4 (about 0.5 to 1% in each quarter). This, however, will just take overall growth down from our previous expectation of a 3% to 5% annualised range in Q3 to a 2% to 3% range instead the top end of which is still close to the trend pace of the US economy. Recovery should start in Q4, however, and be gaining momentum in Q1 2006. Such an outcome in the US will prove to have a minimal impact on the UK economy.

Economic indicators
UK economic indicators this week are likely to focus on price and wage inflation, Monday, Tuesday and Wednesday, and retail sales, on Thursday. Given oil price rises in recent months, we look for another increase of over 1% in producer input prices in August. Consumer prices are still expected to remain above the 2% target, as previous petrol price increases come through. Wage inflation is expected to come in on or just above 4% a year, but there is a chance that unemployment falls marginally in the month. Surveys are showing that retail sales growth may remain weak in August, but after the fall in July there may be a small rise in the month. Overall, the data are expected to confirm that the MPC is likely to keep interest rates at 4.5% for the next few months.

Trevor Williams, Chief Economist
trevor.williams@lloydstsb.co.uk
www.lloydstsbfinancialmarkets.com
Lloyds TSB Bank,
Financial Markets
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Faryners House,
25 Monument,
London EC3R 8BQ
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