Berson's Weekly Commentary
Economic Commentary
September 6, 2005
The national economic impacts of Hurricane Katrina.
Beyond the personal tragedies occurring daily in the wake of Hurricane Katrina, the storm is certain to have significant economic effects. The biggest of these impacts by far will occur in Southeastern Louisiana (especially in the New Orleans MSA) and coastal Mississippi and Alabama. But the storm is proving to have significant national effects, as well. The most noticeable, of course, has been the swift climb in gasoline and natural gas prices to record levels as a result of damage to oil drilling, refining, and distribution facilities (or to the electrical grid necessary to run them). The run-up in gasoline prices has been especially severe, in large part because of the tight inventory situation for gasoline before the storm arrived. Data in Figure 1, which come from the Department of Energy's This Week in Petroleum publication (dated August 31, 2005), show just how tight that inventory situation was before the storm.
This skyrocketing in energy prices is fundamentally different from the increases over the past year. Most, if not all, of the previous rise in prices came from a “demand shock” --that is, the demand for energy products grew faster than the supply of those products. While unpleasant, such price increases don't by themselves result in slower economic growth. Figure 2 shows a stylized example of a demand shock on aggregate demand and supply for the entire economy, where demand growth exceeds supply. This demand shock results in faster economic activity, but at the cost of higher inflation --exactly what has occurred over the past year.
The current situation can be viewed as a supply shock --where the aggregate supply curve for the economy shifts upward, meaning that economic growth slows and inflation rises, as shown in stylized fashion in Figure 3. Supply shocks were the proximate causes of the stagflation of the 1970s, as well as the recessions of 1982-83 and 1990-91. There are two significant questions that stem from this analysis: (1) will growth slow by enough to produce a recession this time (or worse, a period of stagflation), and (2) how will the Federal Reserve react to this changed economic landscape?
At this point, it is too soon to give an informed answer to the first question. We know that the energy supply disruptions, increases in energy prices, and other economic disruptions (for example, the Port of New Orleans leads the nation in terms of tonnage) will slow the economy in the near-term. How big the effect will be, however, depends on how long these disruptions are sustained --and that is still to be determined. If the disruptions are relatively short --say a couple of weeks or less --then the negative economic implications for the national economy should be limited. But if they are long, perhaps measured in months, then the national economy could be significantly hurt.
Because the answer to the first question is still so murky, the answer to the second is as well --with the Federal Reserve not being able to determine at this point if the bigger threat is higher inflation or the possibility of recession. Financial markets have made the determination that this uncertainty will cause the Fed to be very cautious in its tightening. In the week before Hurricane Katrina struck the Gulf coast, futures markets expected a year-end federal funds rate of 4.25 percent. Today, that expectation is 3.75 percent (still above the current rate of 3.50 percent). Our view is that the Fed will bring the federal funds rate up to 4.00 percent by the end of 2005, which would represent a modest reduction in monetary accommodation in the face of current economic uncertainty.
Not only is inflation sure to pick up in the near-term as a result of the energy shock, the August employment report was fully consistent with an economy growing above trend, and thus putting additional upward (albeit modest) pressure on inflation. Moreover, previous natural disasters have resulted in a pickup in economic activity in the months, quarters, and sometimes years after the event as a result of reconstruction --and the bigger the event, the bigger the economic bounce from reconstruction. This suggests that economic activity could be boosted in 2006. A combination of higher near-term inflation and a pickup in growth next year would seemingly justify further modest tightening of monetary policy. But this depends crucially on the longevity of the energy disruptions, which, as mentioned above, are still the big unknown. Given the Fed's risk management objectives (mentioned by Chairman Greenspan in recent remarks in reference to the potential for deflation in 2002-3), it is reasonable to assume that it will be cautious in its policy actions until the energy picture is clearer.
This will be a small week for economic indicators, all of which will be swamped by new news on energy production/provision from the Gulf region.
On Tuesday, the Institute for Supply Management's (ISM) non-manufacturing index should be little changed at around 60.5 August --indicating strong expansion in the non-manufacturing portion of the economy.
On Wednesday, revisions to the second quarter productivity and costs report are expected to be small --with nonfarm business productivity rising by 2.2 percent (annual rate) and unit labor costs up by 1.3 percent.
On Thursday, wholesale inventories are projected to rise by 0.7 percent in July --equal to the prior month.
Also on Thursday, consumer credit outstanding is expected to grow by a strong $9.5 billion in July --pushed up by robust auto sales.
Additionally on Thursday, initial unemployment claims are expected to jump to around 340,000 for the week ending September 3rd --the first signs of the impact of Hurricane Katrina. Because so many people couldn't get to claims offices (or the offices were destroyed), this figure is sure to rise in coming weeks.
Finally, on Friday, import prices for August are projected to rise by 1.3 percent --pushed up by climbing energy prices (pre-Hurricane Katrina).
David W. Berson
Fannie Mae Economics
charts at the link:
fanniemae.com |
