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Wednesday, Sep 21, 2005

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Time for a Fed pause?

S. Balakrishnan

The scales on the eve of the FOMC meeting seem evenly balanced.

IT seemed a done deal but is suddenly up in the air. By the time this column appears, the US interest-rate setting body, the Federal Open Market Committee (FOMC), would have met and decided what it should do.

Before Katrina, it was more or less universally agreed that rates would be upped 25 basis points. Now a significant number thinks the Fed could pause.

A market economy relies heavily on confidence among households and business (what John Maynard Keynes called `animal spirits') and confidence has been considerably dented by Katrina - so much so that the Bush-headed Republican Administration after allegations of callous neglect in the immediate aftermath of the hurricane has vowed to take complete charge of the situation and rehabilitate all those destituted and do the rebuilding out of federal funds.

Does the Fed have a role here? It is the first time that it has faced a natural disaster of this magnitude. In the past it has tackled (successfully) direct and derived (e.g., 9/11) financial market crises.

The invariable response was to inject liquidity and cut interest rates. On one occasion, the Fed even put together a financial package to prevent the collapse of Long Term Capital Management from endangering the system. No such risk exists now.

Apart from a short-lived spike in the price of oil, markets have remained calm and stable. Would the Fed be justified in passing this opportunity to raise rates as it has done at every meeting since June 2004?

Katrina is not alone in supporting the case for a pause by the Fed. In fact, there are quite a few other things that must be causing Mr Greenspan, the Fed chief, some worry. Top of the list obviously is oil prices.

With energy eating up more and more of living costs, consumer and business confidence, as emerging from recent surveys, is ebbing. Other data too do not give the feeling of an economy going gangbusters.

The possibility of a slowdown, which predates Katrina, will increase if high oil rates persist. It is remarkable that voices warning of inflation because of the rise in energy are far fewer than those warning of a downturn. To the latter must be added such distinguished institutions as the IMF.

Mr Greenspan probably shares this view. Nowadays, he worries more about asset bubbles from spiralling house prices. On energy, his take is that it there is the risk of the economy tippling into recession.

Increasing interest rates might worsen the situation but keeping - or cutting them - could result in more asset price inflation.

Thus the scales on the eve of the FOMC meeting seem evenly balanced.

One can bet that the decision and prognosis as reflected in the post-meeting statement will rock markets one way or the other the moment they are announced.

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