Will the Fed pause this month?

The aftermath of Hurricane Katrina has seen some US econobloggers fear the worst. James Hamilton warns that, coupled with higher energy prices, it could put the US into recession. (For other blogger views see William Polley's useful round-up on Katrina and the probability of recession).

But does this necessarily mean the FOMC will leave rates unchanged at its next meeting on 20 September? Certainly Fed funds rate-hike expectations have dropped dramatically post-Katrina, as Dave Altig's latest chart (on the left) shows.

Columnist's views are mixed. Caroline Baum thinks the Fed may pause for political reasons, while John Berry expects them to keep raising rates (hat tip: Economist's View). Federal Reserve and government officials have tended to argue that the national impact of Katrina will be limited, or pose upside risks to growth - see Tim Duy's latest Fed Watch. Some FRB economists have also warned it could push up inflation.

But it's not an easy call. As a thoughtful post by Mark Thoma, How Should the Fed Interpret Expectations That Rate Increases Will Stop?, put it last week:

The Fed faces a difficult decision in coming months. How should the Fed respond to a supply shock? Theoretically, a negative supply shock should lower the natural rate of output which, for any given level of output, would decrease the output gap. 

Fine, so keep raising rates. But what if you can't convince the markets that a pause is unwarranted?

Should the Fed do what it thinks is correct according to the fundamentals, or does it behave according to market expectations it disagrees with? ...Unless FedSpeak can convince markets otherwise (and assuming FedSpeak would want to), it may be prudent from a risk management perspective to pause and wait for expectations of the Fed and the private sector to converge before considering further rate hikes.

In the comments to this post William Polley says: "I really do not think the Fed would lose any credibility as an inflation fighter if it simply paused at one meeting this fall or winter to acknowledge that inflation has been well contained". Mark Thoma agrees, and Edward Hugh "more or less" does too.

But looking at the Fed funds rate expectations chart again, a majority of market participants still favour a 25 bp rate hike to 3.75% later this month. I'm with them - though I don't consider a short-lived pause would do any harm, provided it was clearly signalled as such.

UPDATE: The Economist's Buttonwood column of 6 September discusses what it calls The Perfect Storm, giving both sides of the argument about the hurricane's likely economic impact. (Hat tip: Kash at Angry Bear).

Comments

[Edward Hugh]

Just to clarify one issue, I don't think the Fed will pause, I just don't think it would be any big issue if they did. This is the thing about the measured pace, you miss a month and it doesn't really do much to the upward rise. How's that for hedging your bets :).

What I am signalling loud and clear is that you also need to keep an eye on euro bond markets. The German 10 year bund hit an all-time low of 3.05% this week. This must put an anchor on 10 year treasuries since the yield cannot go up that far without attracting money from europe which brings it back down again. So this - the ceiling on treasuries - is really what I envisage will stay Greenspan, or his replacement's, hand. January isn't it when the change comes? Well the newcomer will have a really nice one to work with if he faces an inverting yield curve just as he draws up his seat.

[Edward Hugh]

James Hamilton is also in the probable pause club:

"Finally, there is the ever-present question of what will the Fed do? I think-- and hope-- that they will take this as an opportunity to pause and see what these developments will bring. The market-- which thinks but does not hope-- seems to believe that they might do just that."

Dave at MacroBlog is watching, taking note, but not I think coming down on one side or the other. Since he works for the Cleveland Fed this is undoubtedly very proper of him.

All in all, it's a close call.

[Nike Air Pippen]

I like your post. thank you.