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.]