- The Washington Times - Friday, September 9, 2005

In addition to her impact on the major macro-economic variables of employment, prices and economic growth, Hurricane Katrina could also have pronounced effects upon the tools of policy-makers, including both monetary policy and fiscal policy. Before the impact recedes, according to the most dire scenarios, the hurricane might even affect the direction of the business cycle.

It clearly is too early to use the “R-word.” Nevertheless, there is so little slack in the world oil market that another major jolt (such as a coup or a terrorist strike) could conceivably send the price of oil into triple digits and the U.S. economy’s growth rate into negative territory.

Before Katrina hit the Gulf Coast, an intensifying demand-side shock had already pushed the price of oil from less than $10 per barrel in 1998 to more than $60 recently. These demand pressures, which had proved to be manageable so far, manifested themselves through relentlessly rising petroleum requirements in America and China. To these demand pressures, however, Katrina has now added a huge supply-side shock by temporarily shutting down more than 90 percent of oil output in the Gulf of Mexico, where 27 percent of U.S. crude oil is produced, and by devastating the Gulf Coast, where more than 10 percent of U.S. refinery capacity is located. Pipelines carrying petroleum products to the Northeast and Midwest were also damaged. Moreover, major damage was sustained by production and pipeline facilities for natural gas, which heats houses in the winter and fuels electricity-generating power plants and petrochemical plants year-round. Oil output in the Gulf has rebounded to 50 percent of pre-Katrina levels. But the oil-refining situation remains so dicey that the White House, according to the Financial Times, has instructed U.S. refiners to postpone scheduled maintenance.

The Congressional Budget Office has projected that Katrina could chop off one-half to a full percentage point from the economy’s growth rate during the second half of this year. Also, employment could decline by 400,000 jobs through the end of this year. Given the 4 million jobs that have been created during the past two years and the economy’s 3.6 percent growth rate over the past four quarters (with comparable annualized growth projected for the second half of 2005), these hits would be manageable. This is especially true considering the CBO’s forecast that “[e]conomic growth and employment are likely to rebound during the first half of 2006 as rebuilding accelerates.” This is the optimistic scenario.

There are no shortage of pessimists. The president of the Federal Reserve Bank of Chicago is understandably worried that “unfavorable cost developments are more likely to pass through to core inflation,” which excludes energy and food. In the aftermath of Katrina, the Fed has come under pressure to suspend its 14-month campaign of raising its short-term target interest rate to a “neutral” level, where it neither enhances growth nor reduces it. If inflationary expectations take off at the same time the world oil market sustains another jolt following Katrina’s, the Fed may feel compelled to squelch inflation before it erupts, causing the economy to dip. It is worth recalling that the last time the Fed accommodated soaring oil prices produced by a supply shock, the eventual result of the inevitably gruesome tightening was the deepest postwar recession.

On the fiscal front, Katrina has already elicited two budget requests totaling more than $62 billion. A figure that is not much different from what the United States spends on military operations in Iraq each year, the $62 billion Katrina downpayment is likely to be dwarfed by future Katrina-related spending needs.

With U.S. energy expenditures this year likely to reach their highest proportion of GDP in 18 years and with the cost of natural gas for home-heating likely to rise by more than 70 percent this winter compared to last, consumer spending on other goods could take a hit, placing downward pressure on the economy. With the price of oil having more than doubled in the past two years and petroleum imports having recently passed the 14-million-barrel-per-day level for the first time ever, the trade deficit could soar, placing great downward pressure on the dollar, whose decline would further intensify inflationary pressures. Keep your fingers crossed and hope that the extremely tight energy market does not experience another supply shock.

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