To Raise or Not to Raise?

That is the question facing the Fed.  Greg Ip from the Wall Street Journal tells us what he has learned:

Katrina Stirs Up Rate Dilemma As It Hits Growth, Lifts Prices, by Greg Ip, Wall Street Journal:  ...Federal Reserve Chairman Alan Greenspan faces an unusually delicate challenge in deciding whether Hurricane Katrina should force a pause in the Fed's 14-month campaign to raise interest rates. The storm has hurt near-term economic growth prospects, which normally would call for lower interest rates, but it also has elevated prices and potential inflationary pressure, which normally would call for higher interest rates. The question facing Mr. Greenspan and his colleagues is: Which is the dominant concern?...

Fed officials say they will see how markets and the economy behave between now and their next meeting on Sept. 20 before deciding what action to take. ... Fed officials haven't ruled out a pause but disagree with some of the rationales circulating on Wall Street. They dispute that raising rates would appear unseemly so soon after a national tragedy. They agree there will be a hit to economic growth, but some also believe inflationary pressures will be aggravated by higher energy prices. But officials also believe that if they pause, they can use the accompanying statement to keep the option of resuming rate increases on the table... But several Fed officials reject this argument. They believe it is a mistake for the Fed ever to subordinate its goals of low inflation and maximum growth to political considerations. Moreover, they fear that pausing for noneconomic reasons actually could undermine confidence by suggesting the Fed is more worried about the economy than it actually is... Fed officials say there may be additional effects if sharply higher gasoline prices seriously erode consumer confidence. They will have little firm data on Sept. 20, and pausing would give them time to collect some. Some officials say they could give that as a rationale in the accompanying statement, while signaling an intention to keep raising rates once they're confident the impact is transitory. If the pause turns out to have been unnecessary, the Fed could make up for it with half-point rate increases later. ... But for some Fed officials, Katrina merely has amplified concerns they already had that higher energy prices were working their way into underlying inflation. While higher oil prices might reduce growth, "there is also a risk on the inflation front, and the risk is higher now than it was a year ago," Federal Reserve Bank of Chicago President Michael Moskow said yesterday. With the economy running close to capacity, businesses are more likely to pass higher energy costs on to other goods and services ... If inflation accelerates, it could become embedded in workers' and companies' wage-and-price behavior, he said. "The Fed would need to respond accordingly in order to restore price stability."

One final note. If you play the expectations game hard enough, you can tell whatever story you need to support your position.  I’ve heard that lowering rates will increase confidence due to the stimulus it will provide.  Here we also hear that lowering rates will signal the Fed is worried about the economy and cause pessimism.  I expect the Fed to stick to its view of the output, employment, and inflation fundamentals rather than trying to outguess the public and set policy according to how it thinks the policy will be interpreted.