The financial markets have grown increasingly comfortable with the idea that the Fed will hike short-term interest rates on Tuesday (Sept. 20) even in light of the devastation caused by Hurricane Katrina, and economists are essentially in agreement.
According to CBS MarketWatch, the federal-funds futures market is currently pricing 96% odds of an interest rate hike at Tuesday’s meeting.
In general, economists believe that the decision is a much closer call, but ultimately think that the market has it right.
“There is not much puzzle, any more, in people’s minds that the Fed will tighten policy, although there are some holdouts,” said Robert Dederick, president of RGD Economics.
Echoing the sentiment expressed by many economists, Bill Cheney, chief economist at John Hancock, said he had thought – right after Katrina – that the Fed would pause, but now believes the Fed will continue to raise rates by a quarter percentage point to 3.75%.
Such leading Fed watchers as Bill Dudley of Goldman Sachs and former Fed Gov. Laurence Meyer have also switched to call for a rate hike in the last few days.
A key factor for these economists is the fact that the few speeches by Fed officials since Katrina have not even suggested the central bank might pause in the wake of the hurricane.
“If I had to come down right now, I’m veering towards saying they are going to tighten anyway because they like to be transparent and they haven’t even hinted that they will pause,” Cheney said.
Diane Swonk, chief economist at Mesirow Financial, said Fed officials believe that pausing now would make it hard to start up again.
“They might as well take this one. It is priced in the market. The market will get reassured that the world is not falling apart,” she said.
This would be the eleventh straight quarter-point rate hike for the central bank, but the first real challenge for policymakers.
Before now, the logic behind the rate hikes was clear. The Fed saw rates as too low for a strong economy and was seeking to slowly bring rates up to a more neutral level without disrupting growth.
But in the wake of Katrina, there are drastically conflicting views that the higher energy costs may slow consumer spending enough to push the economy into recession or lead to a burst of inflation.
There is also the political pressure on the Fed not to appear too callous.
“To keep tightening now without any major concession to the suffering will look a little heartless and be bad PR for them,” said Cheney of John Hancock.
Some market analysts warn that no hike by the Fed would quickly lead to a negative market reaction.
Tony Crescenzi, chief bond market strategist for Miller Tabak & Co., said a pause would quickly lead to higher commodity prices and higher long-term interest rates.