Expert View: As the waters recede, expect US rates to keep rising

Well, that was certainly the financial markets' initial reaction. But comments from officials are prompting second thoughts. The markets have rightly switched back to the view that the Fed will raise its key rate to 3.75 per cent on Tuesday. What they seem to be missing is that the logic behind this current expected rate rise may apply with as much force at the Fed's November and December meetings.

So why is the Fed likely to shrug off the economic impact of Katrina? It is undeniable that a huge chunk of wealth has been destroyed and that economic activity will be depressed for at least a few weeks. Yet the Fed will reckon that skipping another quarter-point rise in interest rates is not an appropriate response to this kind of "supply shock". Before long, reconstruction spending will literally make up for the lost ground.

The broader-based effect on economic activity arising from the collateral damage to oil and gas supplies looks likely to be less than at first feared. Oil prices have settled back after an initial panic spike, helped by the decision to release official reserves.

More generally, Fed officials have extolled the resilience and flexibility of the US economy. Even prior to Katrina, oil prices were rising strongly and yet the economy was growing rapidly. Indeed, but for Katrina, it looked to be growing a little too quickly for the Fed, with overall output rising at an annualised rate of around 4 per cent.

With the economy growing rapidly and unemployment falling, many officials are anxious about rising inflation. So-called "core" inflation (with the effect of energy and food prices stripped out) is at close to 2 per cent - the top end of the Fed's comfort zone.

At the same time, the Fed will also have noted that the financial markets are hardly panicking about the damage wrought by Katrina. The insurers have taken a hit, but the stock market as a whole has been remarkably unmoved.

Meanwhile, although long-term yields in the bond market are off their post-Katrina lows, they remain well below where they were in early August. With yields on 10-year Treasury bonds at less than 4.2 per cent, costs for both corporate and personal borrowers remain remarkably low. Bearing in mind that most American homebuyers have mortgages linked to long-term rates, this suggests that the US housing market will remain hot. The Fed, like the Bank of England before it, has recently voiced its concern that the surge in house prices will end in tears.

For these reasons, the Fed is likely to conclude on Tuesday that not raising interest rates would send out the wrong signals. Even if it tried to portray a "no change" decision as a mere pause, some market observers would still see it as a sign that rates had peaked. This could drive bond yields even lower, giving the economy an additional, unwanted, boost.

The risk of such a misinterpretation has been heightened over the past two weeks as the markets have gone back to thinking that rates are about to go up. Nowadays, the Fed rarely goes against expectations immediately prior to its decision, and then only if it wants to send a strong signal.

However, there is a sting in the tale. One of Katrina's lingering effects on the markets is that they still expect the Fed to pause on raising rates at one or both of its meetings in November and December. Yet, by then, barring more shocks, the US economy should be in even better shape than it is now. The markets may have to tune into the idea that the Fed is not going to put its rate-rising strategy on hold until next year.

Mark Cliffe is chief economist at ING Financial Markets