South-Westerns' Economic News Summaries
Natural Disasters and the Fed
Topic Monetary Policy
Key Words

Hurricanes, Interest Rates, and Energy Prices

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Reference ID: A136439471
News Story

Historically, the central bank has been reluctant to waver from a policy course in response to a natural disaster such as Hurricane Katrina or Rita. Fed officials and many independent analysts believe the economic impact of such disasters is normally limited to the impacted area, and short-lived in duration.

More often than not after a natural disaster like a hurricane, the economy will slow and unemployment will rise in the time period immediately following the event. However, the slowdown is usually followed by an increase in economic activity when the rebuilding process begins. What made this event different was the large impact that Katrina and Rita had on major oil refineries and offshore drilling platforms and the corresponding potential for higher energy prices.

“The widespread devastation in the gulf region, the associated dislocation of economic activity and the boost to energy prices imply that spending, production and employment will be set back in the near term,” the central bank’s Federal Open Market Committee said in a statement. The unusually long statement continued to say, “While these unfortunate developments have increased uncertainty about the near term economic performance, it is the committee’s view that they do not pose a more persistent threat.”

Many private economists agree with the Fed’s position. The hurricane damage and the high-energy prices both amount to a “supply shock”--a disruption in the supply of a commodity-- that naturally leads to higher prices. “There’s not really anything you can do about a supply shock, other than repair the damage,” said Ethan Harris, chief United States economist at Lehman Brothers. “As a policy maker you have to be very careful about putting a lot of stimulus into the economy at a time when capacity has been impaired. “

The Fed’s statement left little doubt that the hurricane had not changed the Fed’s policy course aimed at reversing “policy accommodation” – meaning low interest rates, at a “measured pace.”

The recent hike, the 11th in a row, set the federal funds rate on overnight loans between banks at 3.75 percent. The Fed has been raising rates since June of 2004 and every indication shows that more rate increases are on the way. This recent statement indicates that the Fed’s primary focus is to head off any inflationary pressure in the economy.

Questions
1.

Define the Federal Funds Rate. Who sets the Federal Funds Rate? How does the Federal Funds Rate differ from the Discount Rate? Which is generally higher? Why do banks generally hesitate to borrow from the lowest possible rate?

2. Discuss the notion of a “supply shock” and its impact on prices.
3. Research the make-up and purpose of the Federal Open Market Committee of the Fed.
Source Edmund Andrews, “Unswayed by Storm, Fed Raises Key Rate”, The New York Times Online, September 21, 2005
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