Why interest rates may rise again - despite Katrina

Two weeks ago, as the magnitude of hurricane Katrina sank in, many economists entertained the possibility that the Federal Reserve would pause from its unstinting interest-rate hikes.

But now, despite a spike in energy costs, sagging consumer confidence, and a storm-induced surge in unemployment, the Fed is expected to go forward Tuesday with its 11th interest-rate increase in 11 meetings since June of 2004.

Instead of a strategic pause, the Fed may use a carefully worded statement to explain that the economy faces new uncertainties, and that the nation's central bank is watching the situation closely.

Its calculation, observers say, would be that the government relief efforts are be strong enough, and the economy stable enough, that a monetary rescue effort may not be needed.

Those factors give policymakers leeway to keep tightening interest rates in an effort to make sure that inflation gains no foothold in a growing economy.

It will not be an easy choice. Tuesday's meeting is arguably the first in 16 months at which the Fed committee will face such a delicate analysis of countervailing risks in the economy. Its decision could have significant but hard-to-gauge implications for the health of consumer and business activity in the months ahead.

"The Fed has been kind of on autopilot here for quite a while," says Brian Bethune, an economist at Global Insight in Lexington, Mass. "Now all of a sudden they're going to have to start doing some work. I don't think a robotic response is appropriate here."

His view of what will happen - and what should happen - next is shared by many Fed watchers: Move forward with another 0.25 percentage point boost to short-term interest rates, but use the accompanying policy statement to recognize a complex array of threats.

In addition to the risk of inflation perking up in an expanding economy, there's an opposing risk that the shock of Katrina and higher energy costs could be a major drag on economic growth.

Higher oil prices, present even before the hurricane, have been a common precursor of recessions in recent decades.

Prices for crude oil have fallen somewhat in the aftermath of Katrina, but consumers still face higher gasoline costs - and the prospect of significantly higher heating bills this winter.

"It's taking a little longer [for prices to ease] at the gas pump, and frankly that's making me a little nervous," says Peter Kretzmer, a senior economist in New York who works for Bank of America.

While some worry that rising energy costs will ripple outward into the inflation rate, others say the larger risk is the hit to consumer confidence, as people realize they have less income left to spend on other goods and services.

So far, few economists foresee an energy-induced recession. But the first economic reports to show post-Katrina data will surely have the attention of Fed policymakers.

• Consumer confidence, as measured by a nationwide University of Michigan survey, plunged to its lowest level - 76.9 - since February of 1992.

• The manufacturing outlook also fell sharply in a survey focused on the mid-Atlantic region covered by Philadelphia Federal Reserve Bank. Some 24 percent of respondents said activity was expanding, but 22 percent said it was contracting - leaving the bank's index at a barely positive 2.2, down from a healthier 17.5 in August.

• A New York state survey of manufacturing activity also fell, but less steeply, to a reading of 17, from 23 in August.

• New unemployment claims jumped by 71,000 last week, a surge that was expected, given the thousands of workers and businesses displaced in the states hit by Katrina.

But if all this is enough to prompt close scrutiny, analysts say the Fed can justify another rate hike.

First, the economy was fairly strong before Katrina hit, even with high oil prices. Jobs were finally being created at a steady pace, and consumer spending was strong.

Many expect that consumer confidence will revive as gas prices ease in coming weeks.

Posthurricane spending on recovery efforts could provide a strong fiscal stimulus to the economy.

"The federal response has been much larger than we thought it would be," says Mark Vitner, an economist at Wachovia Securities, a bank based in Charlotte, N.C. "And the money is being spent much more quickly."

And even after another rate hike, the short-term interest rate would be 3.75 percent, a level that many economists see as an "accomodative" position that stimulates economic growth.

The Fed's goal has been to move its benchmark rate gradually toward a "neutral" position - one that allows growth without fueling inflation - of perhaps 4.5 percent by the middle of next year.

Still, it is unclear how real the threat of inflation is. The consumer price index for August, released last week, jumped by 0.5 percent, a large rise for a single month.

The rise is largely due to energy prices. But the recent spike has been so large that, according to Mr. Kretzmer, it could produce an unusually high inflation rate of about 5 percent, annualized, for the second half of this year.

"That's a striking number," he says. "There hasn't been a quarter when inflation averaged 5 percent since the fourth quarter of 1990."

But so far, higher energy prices have not spread significantly into broader inflation. The so-called core rate of inflation, which excludes food and energy, has been running close to a 2 percent annual pace.

Higher energy costs should act as a signal to suppliers to produce more energy, and to consumers to conserve, without necessarily fanning wider inflation, Bethune says.