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Analysts wonder what US Fed's next move will be

"We are clearly in a state of economic uncertainty and the prudent thing to do in such times is to do nothing at all ... The economy was already clearly losing momentum heading into Katrina."

David Rosenberg, Merrill Lynch chief economist

The US Federal Reserve is being forced to rethink its plans for interest rate increases in the face of the calamity spawned by Hurricane Katrina in a strategic economic region, analysts say.

The bond and futures markets have shifted the odds of a further move by the US central bank, which has implemented 10 quarter-point increases as part of a gradual effort to normalize interest rates.

Yields on the bond market have fallen since the storm tore through the southeast as investors bet on a weaker economy.

The fed funds futures market is now priced for a 76 percent chance the Fed's target interest rate is lifted to 3.75 percent from 3.5 percent when the Fed meets on Sept. 20, down from a 90 percent chance earlier this week and 100 percent odds priced in last month.

Merrill Lynch chief economist David Rosenberg suggested that the Fed may stop its rate-boosting cycle immediately in the face of the disaster.

"We are clearly in a state of economic uncertainty and the prudent thing to do in such times is to do nothing at all," Rosenberg said. "The economy was already clearly losing momentum heading into Katrina."

SUBTLE SIGNALS

Rosenberg said the fact that Fed chairman Alan Greenspan met with US President George W. Bush after Katrina hit last week was significant.

"It is basically a subtle way to flash to the market that the negative economic consequences are resonating and that the Fed may not just look at this as a temporary soft patch this time," Rosenberg said.

Some analysts agree, arguing that Greenspan does not want to risk pushing the US economy into recession just before he retires in January.

"The interest-rate markets have moved to swiftly price in one last act of enlightened risk management from Fed chairman Greenspan in the form of a tightening pause," said Michael Wallace, economist with Action Economics.

Katrina has been so devastating because aside from leveling New Orleans and the surrounding area, it affected major oil refineries, ports, pipelines and highways connecting the region to the rest of the country.

HARMFUL DIVERSION?

The surge in energy costs threatens to divert tens of billions of dollars from consumers and dent spending on other items, thus crimping economic growth.

But a number of economists dispute the argument that the Fed should shift gears immediately.

Lehman Brothers economist Ethan Harris said "the markets have forgotten two lessons from prior natural disasters," referring to Fed action in the case of two major California earthquakes in recent years.

"The national economy usually weathers these storms with relatively minor damage," Harris said.

Harris said the devastating floods brought by Katrina represent a "supply shock" that may raise prices and not a "demand shock" that will harm long-term growth.

"In the past the Fed has approached supply shocks with a jaundiced eye," he said.

Other analysts say Greenspan and company will wait to see how quickly the disaster recovery proceeds and whether energy prices will settle to a less punishing level.

INSIDER'S VIEW

Among the few comments from the central bank, Philadelphia Fed president Anthony Santomero said Katrina's impact "may slow the rate at which the economy will grow for a time, but the expansion is strong enough to withstand them."

Nariman Behravesh, chief economist at research firm Global Insight, said the special circumstances of this event -- crimping the US energy industry and the major commodity port at New Orleans -- mean "a large national economic impact" that will shave between 0.5 percent and 1.0 percent from growth in the third and fourth quarters.

COMPLICATED TASK

"The uncertainty about the damage from Katrina will make the Fed's task far more complicated," Behravesh said.

He argued that "at most, the Fed will hike the federal funds rate another 25 basis points before the end of the year, probably at this month's meeting."

After that, the economist said, "Mr Greenspan and his colleagues are likely to take a `wait and see' attitude for a couple of meetings."
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