Economy slowing? Inflation brewing?

Fed expected to hint about Katrina's impact

Author: Kathleen Lynn

Published: September 19, 2005

Since the last time the Federal Reserve raised interest rates, Hurricane Katrina has shaken the economy, wiping out tens of thousands of jobs and boosting gasoline prices.

So the stakes will be high when the Fed meets Tuesday to consider raising interest rates, a decision that affects every American who carries a credit card balance, applies for an adjustable-rate mortgage or holds a savings account.

While most analysts predict the Fed will continue its path of raising interest rates a quarter-point at a time, economists are eagerly awaiting the Fed's commentary.

Will the Fed, troubled by the shuttered businesses and lost jobs along the Gulf Coast, hint that the economy is losing steam? Or will it raise concerns that high fuel costs, combined with federal disaster-relief spending, could cause inflation?

"There is a lot more of a guessing game now than in the 10 previous interest rate hikes," said Greg McBride, an analyst with Bankrate.com.

What Wall Street wants is a reassurance that the economy can grow without igniting inflation.

But even in normal conditions, that can be tricky. The Fed typically lowers interest rates, as it did in the early part of this decade, when the economy needs stimulation. Lower rates give consumers and businesses more money to spend.

But when economic growth picks up, as it has in the past year or two, the Fed worries that making money too readily available will spark inflation, as more dollars chase goods and services.

The Fed has been raising rates since mid-2004, a quarter of a percentage point at a time, in an effort to control inflation. The federal funds rate, which banks charge each other for short-term loans, now stands at 3.5 percent, up from 1 percent in the first half of 2004 - a 46-year low.

As a result, most consumer interest rates also have risen. Borrowers pay more and savers get more. Credit cards now charge around 13 percent, on average, while one-year certificates of deposit are paying an average of 3.65 percent, according to bankrate.com.

Mortgage rates, however, have remained below 6 percent, continuing to feed a housing frenzy that has pumped up prices nationwide. The rebuilding of the Gulf Coast, meanwhile, might continue to push up housing prices nationwide as the demand for building materials increases.

Economists aren't sure why mortgage rates haven't risen, but several point to the flow of foreign capital into U.S. markets.

Since last year, economists have been nearly unanimous, and correct, in their predictions the Fed would raise rates a quarter-point at a time. That remains the consensus, at least for this week's meeting.

"I'm leaning toward the idea that they'll raise rates this month, with the idea that they will evaluate economic data between now and the November meeting to determine the next step," McBride said.

"I'm betting the Fed will raise interest rates a quarter-point," said Keith Gumbinger, vice president of HSH Associates in Pompton Plains, which tracks mortgage rates and other interest rates.

Gus Faucher, a senior economist at Economy.com in West Chester, Pa., said Katrina's effects will not be strong enough to push the Fed off its course of raising rates.

"The economy remains fundamentally strong," he said.

Before the hurricane hit three weeks ago, economists expected the national economy would grow at a healthy rate of 3 percent to 4 percent in the second half of the year, according to the Congressional Budget Office. The hurricane is expected to reduce the rate of growth by between a half-percentage point and one percentage point.

The hurricane, of course, devastated the local and state economies of the Gulf Coast. But on the national level, its main economic effect has been to push up fuel prices because refineries and pipelines were damaged. Gasoline now costs about $3 a gallon in much of the nation, which is likely to curb consumer spending on other products and services. In addition, businesses must pay more to produce and ship goods.

"Gasoline going from $2 to $3 - that takes a lot of money out of a lot of people's pockets," Gumbinger said.

In recent speeches, three Fed governors all said the storm's damage will "weigh on economic growth in the second half of this year," Faucher said. But, he added, the governors also said the damage will be small and temporary.

And by early next year, rebuilding along the Gulf Coast will stimulate the economy, economists predict.

"As harsh as it seems, natural catastrophes are usually stimulative to the economy, simply because of all the rebuilding," said Rudolph Penner, a senior fellow at the Urban Institute and a former director of the Congressional Budget Office.

In any event, the Fed is probably drawing close to the end of its chain of increases, said Christopher Burdick, director of economic analysis at the Schwab Center for Investment Research. Most analysts, he said, expect the federal funds rate to come to rest at about 4.25 percent, not much higher than the current 3.5 percent.