So much for taking a hurricane break. The Federal Reserve today raised interest rates for the eleventh consecutive time, hiking Fed funds by 25 basis points to 3.75%.

Some analysts had speculated that the central bank would pause, if not stop its relentless drive to tighten monetary policy in response to Hurricane Katrina. And for a time, right after the images of a devastated New Orleans began hitting the airwaves, it seemed eminently reasonable that the central bank might take a breather, if for no other reason than out of sympathy. But as it turns out, Chairman Greenspan and his colleagues weren’t intimidated by the weather, the graphic imagery, or anything else tied to Katrina. The Fed, in case you didn’t realize, is all business al the time.
Yes, central bankers watch CNN, and recognized Katrina’s tragic impact. “While these unfortunate developments have increased uncertainty about near-term economic performance, it is the Committee’s view that they do not pose a more persistent threat,” the Federal Open Market Committee advised.
If there’s any hurricane legacy affecting Fed thinking it’s one of raising inflation expectations by way of energy. With so much oil and natural gas production and distribution knocked off line because of the hurricane, energy prices have soared. That feeds directly into the inflationary pipeline, the Fed reasons. Again, from the FOMC statement today: “higher energy and other costs have the potential to add to inflation pressures.”
The bond market seemed to buy the argument that the Fed should keep tightening so as to thwart an energy-driven jump in inflation. The yield on the 10-year Treasury Note was nearly unchanged today, closing the session at around 4.24%.
Why does the bond market like rising interest rates these days? For the moment, it’s the preferred prescription to the current economic challenges. “If these inflationary considerations were not enough to stiffen the Fed’s resolve to stick to its plans for future rate hikes, policymakers are also well aware that Katrina, like most natural disasters, will likely stimulate the economy,” Milton Ezrati, senior economic strategist at Lord, Abbett & Co., told DowJones via SmartMoney before the central bank’s rate announcement. Stimulate because rebuilding and government spending will filter out into the economy, putting money in contractors’ pockets and some inflationary zest into the pricing pipeline.
News of yet another Fed funds hike was also celebrated by forex traders, who chased the greenback today. “The dollar is firming because the Fed is utterly unpersuaded that Katrina did any significant [economic] damage. Threats to growth are merely temporary,” T.J. Marta, senior currency strategist with RBC Capital Markets in New York, tells Reuters today.
Whatever the economy has in store for the markets, there’s no question that the gap keeps widening between U.S. rates and their equivalent in Europe. The 10-year Treasury now yields more than 100 basis points over its German equivalent, for instance. That’s due in no small part to the European Central Bank’s stubborn refusal to raise interest rates of late vs. a Fed that’s intent on just the opposite. Then again, maybe the do-nothing monetary routine that’s playing abroad is about to end, or so one could argue after European Central Bank President Jean-Claude Trichet’s admission last week that the energy bull market threatens to elevate inflation on the Continent.
But by some accounts America’s longer-term economic health may depend on a lesser premium in U.S. rates relative to Europe. To the extent that higher relative interest rates boost the dollar, the stronger greenback makes American exports less alluring. That’s just what the doctor didn’t order, warns a new Levy Economics Institute research paper, The U.S. & Her Creditors: Can the Symbiosis Last?
A rise in exports relative to imports may be the only solution for what ails threatens the American economy, argues the Levy paper. “If the trade deficit does not improve, let alone if it gets worse,” the report warns, “there will be a large further deterioration in the US’s net foreign asset position so that, with interest rates rising, net income payments from abroad will at last turn negative and the deficit in the current account as a whole could reach at least 8.5 per cent of GDP.” Eight-percent-plus would represent uncharted territory in terms of high degree of red ink relative to the size of the U.S. economy. If that level of doubt found its way to these shares, it could arguably set off a chain of events that would be something less than advantageous from an investing perspective, such as higher interest rates to compensate for the risk. In turn, the higher rates would only exacerbate the trade deficit, and on and on.
That’s assuming the dire future comes to pass, as sketched out in this research. But using recent history as a guide, no one’s made any money predicting that the trade deficit would reverse course. Will the future be any different?
Perhaps not, assuming the gold market harbors the truth about inflation expectations. The precious metal continues to hover near 17-year highs of late. If gold has any sway at the Fed, more interest rate hikes are coming, which means more support for the dollar and perhaps even deeper trade deficits.