Monetary policy

During the aftermath of Hurricane Katrina, financial markets braced for the worst, reassessing the potential trajectory of Fed policy. A number of market observers opined that a 25 basis point (bp) rate hike in September, which previously had been viewed as a near certainty, might be off the table because of Katrina. Former Dallas Fed President Robert McTeer even suggested that a rate cut could be in the cards.

Cooler heads prevailed in the following week, as comments from several Fed officials as well as prominent Fedwatchers in the media indicated that, pending further evidence to the contrary, the Federal Reserve could continue to remove monetary accommodation at a measured pace. The latest data suggests greater price pressure than previously assumed and, arguably more importantly, inflation expectations have risen because of the supply shock imparted by the Katrina disaster. Moreover, the expansion of fiscal spending could further encourage the Fed to continue raising rates at a measured pace.

Monetary policy has limited effectiveness against oil supply shocks; within two weeks of the storm, the Fed funds futures strip was again pricing in additional Fed tightening. There are two FOMC meetings in the fourth quarter — Nov. 1 and Dec. 13. The pricing of the November and December Fed funds futures implies that although the Fed is likely to hike in November, it may pause in December. The Fed funds target rate is expected to be at 4.00 percent by the end of the year. That said, as of mid September, the market had not reached a new equilibrium and still appeared to be correcting the overshoot of expectations in the immediate aftermath of Katrina. (The Fed did, in fact, raise rates on Sept. 20 by 0.25 bps to 3.75.)

Federal Reserve officials have frequently indicated their course is data dependent. And the key data does not appear to be the inflation gauges, per se. The Fed sees the knock on growth from the hurricanes to be temporary. Rather, the FOMC appears committed to removing monetary accommodation unless it sees a good reason to believe this has been accomplished. Although core inflation measures remain in check, the rise of unit labor costs, amid slower productivity and the tightening of labor market conditions, may be a cause of concern. Also, the spread between the TIPs (Treasury’s inflation protected notes) and the regular U.S. Treasuries had widened in mid-September to a four month high, signaling inflation expectations have risen.