Fed Watch: Minutes + Katrina = More Tightening

Tim Duy watches the Fed from the Oregon Coast:

A quick missive from the beach while my son is taking a nap in anticipation of a hard afternoon playing in the sand…

Reading the news on Katrina and the Fed minutes side by side, I can’t help but think the damage in the Gulf States only gives the Fed more license to hike rates further.  This, I believe, is at odds with the opinions of almost every commentator I have seen on CNBC who seem to believe that the solution for every economic disruption is a rate cut.  While I think that has been true for the entirety of the Greenspan Fed to date, I sense the story will not be the same this time.

To get a handle on the Fed’s state of mind, turn to the staff’s forecast:

In the forecast prepared for this meeting, the staff raised its projection for economic growth over the remainder of 2005 in light of incoming data suggesting greater near-term momentum in aggregate demand. At the same time, however, it trimmed the growth rate forecast for 2006, reflecting the effects of higher energy prices, higher long-term interest rates, and the somewhat slower growth of productive capacity implied by the annual revisions to the national accounts. The output gap was predicted to be essentially closed by the end of this year…. Notwithstanding recent benign readings on inflation, the forecast for core PCE inflation was raised somewhat, owing in part to the recent further rise in energy prices and, in light of the revisions to historical data, a higher assumed trajectory for the nonmarket component of core PCE prices.

Note the story for 2006, particularly higher energy costs and slower capacity growth, both of which will tend to exert upward pressure on prices.  Moreover, interest rates have dropped since this forecast was revealed to the FOMC, suggesting stronger demand than expected three weeks ago.  The conclusion of the staff is to look for higher core inflation next year – not exactly what a central bank already on a tightening campaign is interested in seeing.

Next from the minutes:

Participants viewed the increases in market interest rates over the intermeeting period as an appropriate response to the stronger economic outlook. A few participants voiced concerns that still-low interest rates and insufficient recognition by investors of the dependency of the Committee's policy expectations on economic data were continuing to foster an inappropriate degree of risk-taking in financial markets.

Sounds like Greenspan’s warning from Jackson Hole.  Note also that interest rates have confounded the Fed once again and turned downward, only exacerbating the worries of those who fret about the consequences of this extended period of low rates.  Of course, some of those at the FOMC meeting are concerned that demand will slow quicker than anticipated…

Another participant mentioned, however, that recent sluggish growth of the monetary aggregates suggested that the stance of policy was not overly accommodative. Moreover, with a higher proportion of mortgages now tied to short-term rates, it was noted that increases in short-term rates could have a somewhat larger-than-usual effect on spending.

I love the minutes – a little something for everybody!  The whole message of the data is then to stay the course:

On balance, current financial conditions, which embedded expectations of future policy tightening, were generally seen as likely to be consistent with sustained moderate economic growth and containment of pressures on inflation in coming quarters.

Notice the term “embed expectations of policy,” which means the high odds traders place in seeing a 4% funds rate (thank you David Altig) at the end of the year.  Would the Fed want to disappoint?  At this point, I think not.

The FOMC ultimately concludes that interest rates will likely have to trend higher, although, as always, they remain data dependent.  As I suggested in my last post, I see the data as supportive of further rate hikes.  Moreover, I tend to view Katrina as having a net inflationary impact, which adds another round of ammunition for the inflation hawks on the FOMC.

As noted by James Hamilton, Katrina disrupted the already strained US refinery industry.  Unleaded gas prices have surged 35 cents a gallon as of 1:30 EST.  Moreover, natural gas prices are sharply higher as well.  The impact, in my mind, is a classic supply side shock; we can’t really argue that this latest surge in energy prices is driven by strong demand, placing the Fed in the famous conundrum – fight weak output, or fight inflation?  But wait, maybe output, nationally, will not be a problem after all.  The Gulf States will need extensive rebuilding as Katrina was likely the costliest storm in US history.  Consider the billions and billions of dollars of construction materials that will be streaming into the region over the next few years.  Possiby enough to offset the impact of slowing housing markets elsewhere…? Something worth thinking about…  Moreover, we still have the problem of a construction worker in Orange County out of work while a job site in New Orleans sits idle for lack of workers.  You guessed it, more structural adjustment for the economy, on top of that which I believe will be driven by higher energy prices.

In my mind, then, the stage is set for an economic situation that is not easily fixed by cutting rates – but instead one that calls for an even stronger commitment to price stability.

[Update:  The conditions in New Orleans have, sadly, deteriorated.  Additional comments can be found here.]

[Update:  White House adviser Bernanke discusses the economic consequences of Katrina.]

Comments

[anne]

Now, it seems to me that last year there was a brief loss of work in Florida after the storms and then a significant construction increase that may have actually fed to the housing boom in Florida in general. Interesting. A stimulus to growth after a brief prief period, along with continued increases in short term interest rates. Makes sense. Alan Greenspan is always telling us how flexible the American economy has become. Paul Krugman has made the same comment about the way in which we weather shocks of such a manner.

[anne]

Remember though, the Fed has been raising a whole year past the last hurricanes and the housing boom was far more widespread than just Florida and may well be about to weaken, possibly seriously.

[anne]

Also, I am saddened for all those effected by the fierce storm but there really has needed to be more preparation for decades. This scenario was discussed by environmental and ecological experts for years, with pleas made for strengthening the natural defenses below New Orleans as well as the defenses in the city. Darn.

[dryfly]

This scenario was discussed by environmental and ecological experts for years, with pleas made for strengthening the natural defenses below New Orleans as well as the defenses in the city. Darn.

There is no way to 'strengthen' the natural defenses below NO that won't involve changing nearly everything people in the whole Mississippi River watershed do from & including NO all the way to Lake Itasca. The destruction of the delta is NOT the result of a few minor actions on the part of a few greedy people... it is the result of a whole society & the choices we have all made... knowingly & unknowingly.

Given that choice (complete change or NO) in the past or the future, America will choose to sacrifice NO everytime.

BTW - I live less than a mile walk from the Mississippi River... but something like 800 miles above NO... I see the forces causing destruction of the delta each and everyday.

[SKEPTIC]

You seem like a smart enough guy.. etc.
But let me ask you what would it take you to question not whether you are right or wrong but your apparent certainty..
After every adult in the Universe read the same exact FED minutes that you did, and knowing all that you know about Katrina etc. etc.
Interest rate markets exploded, not only has the market started to price out the FED moving three times.. but even moving in November is now a question...

So forgetting where we end up which is irrelevant.. What do you think you're missing??

If you had been trading today and betting enough to be meaningful.. you would have been wiped out..

[brad]

tim -- could you shoot me and email when you get back from the coast; i had assumed you were incommunicado.

[dali lama]

Hi -- I know I'm missing something: Energy surges knockig off a few percentage point of off 4th qrt GDP. And the fed tightens in response to knock off a few more points on top of that?

By my books high energ prices are in the end deflationary -- again I'm missing something.

[Tim Duy]

Thank you all for the important comments.

Dali lama, over the past decade, I would agree that rising oil/gas/energy prices tended to be deflationary. I worry that that is currently not the case - that the rise has been too quick, especially with a final supply side shock, to not be inflationary. In other words, a stagflation type of situation where output suffers as inflation accelerates.

Anne's point is good as well, though - maybe enough tightening is already in the system, it just isn't evident yet.

Skeptic, it looks like I focused on the inflation side of the story, while many others focused on the deflation side. For the record, I finally saw a commentator worried about the inflation side of the picture. But it was on FOX news, which quickly made me doubt my entire position.

It may be also that the market is starting to sense something the Fed doesn't - that is always a dangerous time to be a Fed watcher.

[anne]

This may have been different; I know, I know. The damage from the storm and lack of preparedness for decades may be more sadly debilitating that we have understood. We have been taught all to well to slough off scientific consensus in examining problems. What is ecology after all? Well, Darwin began the field but it was largely ignored even by biologists till the 1960s. We had best pay attention now.

[anne]

http://www.nytimes.com/2005/08/31/business/31econ.html

Damage to Economy Is Deep and Wide
By EDUARDO PORTER

As Hurricane Katrina plowed through the Mississippi River basin, shutting down ports, flooding cities and cutting power lines, economists warned that it was likely to leave a deeper mark on the national economy than previous hurricanes because of its profound disruption to the Gulf of Mexico's complex energy supply network.

"The typical pattern with a natural disaster like this is that the regional economy gets clobbered but you can barely see it in the national statistics," said Nariman Behravesh, chief economist at Global Insight in Lexington, Mass. "This time it is very different because of the impact on the energy infrastructure."

Already, it is clear that much of the economic activity in the gulf region has indeed been clobbered....

[anne]

Notice the long term Treasury is amazingly at 4.01% this morning. Again, this is the most profound bull market in bond since the Depression.

[Lord]

Just as rising short term rates are putting a damper on the housing, rebuilding will help it. I see no reason to deviate from a steady as she goes policy although we should be out of steam by the end of the year.

[skeptic]

Even a bit more hazardous today..
Of course the job of FED watcher only is important at times like this, otherwise we can all go to Macroblog and read the market's consensus probabilities off his pretty charts.

Today the market is pricing about 20% probability that FED will pause in September, much less November...
given that probability... and the clear probability that whenever the FED stops its usually eases withing 5 months.. 10 Year Note Yields at 4.00 seem downright generous.. view them as everybody does as a summary of the expected path of FED policy over the relevant horizon....

That said, being long now is equivalent to betting on the FED stopping by November (50% odds today).. and right or wrong that seems like at the most just a fair bet.. so why bother..

[JohnD]

The altered 2006 growth projections could suggest a *less aggressive rate hike trajectory.*

--From Aug 9, 2005 minutes: "At the same time, however, it trimmed the growth rate forecast for 2006, reflecting the effects of higher energy prices, higher long-term interest rates, and the somewhat slower growth of productive capacity implied by the annual revisions to the national accounts. The output gap was predicted to be essentially closed by the end of this year."

--From the July monetary policy report: Central tendency 2006 GDP projection of 3.25% - 3.5%.

The central tendency projections also reveal both 2005 Q4 and 2006 Q4 unemployment of 5%. In homage to Okun, I'll infer that the Fed's trend growth assumption had been 3.25% - 3.5%. (Comments by FOMC officials are consistent with this assumption as well.)

To the extent 2006 growth expectations were downwardly revised commensurately with a decline in estimates of near-term trend growth, there is not necessarily a direct impact on rates (though the Fed's rate-dependent growth projections make it somewhat ambiguous.) To the extent, though, that the downwardly revised growth expectations stem from higher energy prices and higher interest rates, the 2006 forecast could imply a *less aggressive rate trajectory.*

(Probably doesn't matter, but I'm implicitly ignoring that the August minutes reflect the Fed staff forecast and the central tendency projections reflect individual FOMC members.)