A Fed Pause? Don't Count on It


By Rich Miller Federal Reserve policy has seemed to be virtually on autopilot since Chairman Alan Greenspan and his colleagues began raising interest rates last year. Every six weeks or so, policymakers have bumped up rates another quarter percentage point. And at each meeting, they have issued a statement all but promising to keep on that "measured" path in the future.

Now, though, financial markets are abuzz with speculation that a pause might be in the offing. From former Fed Governor Lawrence Lindsey to Goldman Sachs Chief Economist Bill Dudley, a growing number of analysts believe the central bank will forego raising rates at its Sept. 20 meeting in the wake of the economic devastation wreaked by Hurricane Katrina.

Will it happen? Don't bet the house on it. Based on what Fed policymakers are saying publicly and privately, Greenspan & Co. still look likely to raise rates another quarter-point later this month. But it could opt to change its statement to give it added flexibility in conducting monetary policy in the coming months as its assesses Katrina's economic impact.

THE LAST MINUTES. One possibility being mooted in the markets: dropping the promise of continued "measured" quarter point rate hikes, while retaining the description of monetary policy as accommodative. That would give the Fed leeway to skip raising rates at a future meeting, while making clear that the most likely path for rates will remain upwards.

Before Katarina hit, many Fed policymakers were growing nervous about the inflation outlook. That was evident in the minutes of the Fed's last meeting on Aug. 9, where talk turned to "the risks to inflation as having ticked up." Katrina is unlikely to have altered that assessment much. Indeed, Chicago Fed President Michael Moskow said in a speech on Sept. 7 that he remained "concerned" about the inflation picture.

After four years of solid growth, the economy doesn't have much slack. Manufacturing companies ran their factories at 78.3% of capacity in July, the highest level in nearly five years, according to Fed data. Labor markets are also tightening. At 4.9%, the unemployment rate is already at a level that at least some Fed officials consider to be effectively full employment.

"As the expansion matures, the price dynamics at work in the economy will shift," Philadelphia Fed President Anthony Santomero said in a speech on August 31. The upshot: Companies will find it easier to raise prices, while workers will be able to demand bigger pay hikes.

TRANSITORY BLOW? But what about the hurricane's hit to the economy? There's no doubt that the destruction wrought by Katarina will crimp growth in the near term. In an early assessment, the Congressional Budget Office said on Sept. 7 the storm could reduce growth in the second half of this year by a half to a full percentage point. But Fed officials note that such disaster-driven slowdowns historically have proven to be transitory. Besides, the economy was growing solidly before the hurricane, leaving it better positioned to withstand the impact.

What's different about Katrina, of course, is that it also knocked out a significant portion of U.S. oil and natural gas output. That had the potential to have a more long-lasting effect on the economy. But Fed officials have been heartened by how quickly some of that production has been restored. Also plugging the supply hole: stepped-up imports of gasoline. Partly in response, wholesale gasoline prices have dropped sharply, and on Sept. 7 stood just about 10 cents a gallon higher than they were before Katrina struck.

Of course, the Fed could come under some tough criticism from politicians if it goes ahead and raises rates on Sept. 20. President Bush had Greenspan in for lunch on Sept. 1, after the hurricane struck. While Administration officials maintain that the President didn't ask the Fed to refrain from raising rates, to many in the markets the message in hosting Greenspan seemed clear.

FINAL CHALLENGE. Since then, a parade of congressional legislators -- both Republican and Democrat -- have openly called for the Fed to hold off from hiking rates. But analysts say the central bank could deflect some of that criticism by acknowledging the uncertainties to the outlook and leaving open the possibility of a pause in its rate hiking campaign in the future.

Throughout his 18-year career, Greenspan has shown a deft touch in managing both the economy and the political pressures the Fed faces in conducting monetary policy. Now, Katrina has presented him with one final challenge before he steps down early next year. History suggests he'll be up to the task.

Miller is a senior writer in BusinessWeek's Washington bureau


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