Unexpectedly Intriguing!
September 13, 2005

The Federal Reserve Bank of Cleveland recently released its monthly report of economic trends in the U.S. (available as a 1.11MB PDF document) with a special focus on how a low probability event, in this case the extreme damage wrought by Hurricane Katrina on the Gulf Coast, moved to dominate the center stage of attention in forecasting the economic future of the U.S. The report's authors note what effects the damage done by the hurricane will have on the U.S. economy in the short and intermediate terms:

In the short term, there is little doubt that the storm will harm the nation’s economy through its effect on energy prices. Before Katrina hit, high energy prices already were thought to be taking a toll on consumer spending for other goods and services. But the truth is that it will take some weeks to assess the full extent of the damage to the energy infrastructure and months before it can all be repaired. Consider that the storm destroyed warehouses that contained essential supplies and that skilled labor will be scarce. Moving people and material through the area will be challenging.

Surprisingly, the U.S. stock market posted a small gain for the week of the storm, despite the challenges and the lack of information noted above. The authors of the Cleveland Fed's report speculate on the reasons why this would be the case:

The fact that they did not sell off could be interpreted as a sign of confidence in the nation’s ability to overcome the shock over the medium term. It might also signal a belief that interest rates could follow a lower track than had previously been priced into the market.

What changed were the expectations of the financial market participants of what the Fed's Open Market Committee (FOMC) would do with the federal funds rate. Before Hurricane Katrina, the traders were expecting the FOMC to continue its recent path of regularly increasing the funds rate by 25 basis points at each of the next two meetings of the committee. By September 1 however, following the hurricane, that expectation had changed with the traders now predicting that the probability of the Fed increasing the funds rate by 25 basis points at each of its next two meetings had dropped to 50%. A similar assessment appears to have been made regarding the future economic growth of the U.S.:

Before the storm struck, most market analysts were expecting the pace of economic activity to remain in the range of 3 to 4 percent for the next year or so, despite higher energy prices. They saw high energy prices as the result of strong global demand for energy resources rather than disruptions of supplies. Now that the nation has sustained a supply shock, rising energy prices have a different connotation. If the energy infrastructure proves to be highly resilient, the effects on GDP should be moderate and largely transitory.

In all of this, the role of the financial markets in assessing the impact of a catastrophic event is to serve as aggregator of information, collecting information from thousands upon thousands of people with discrete elements of highly specialized knowledge and representing it in the prices of the financial instruments traded in the marketplace. In that respect, financial markets are an older version of the blogosphere, which has also played a similar role in gathering and disseminating information following the catastrophe. However, where the blogosphere will need several weeks to sort the wheat from the chaff of information (recall the unfounded reports of cannibalism), financial markets have an edge in that they require its participants to put money down on the information being disseminated. This simple requirement works to filter out a great deal of noise.

So, what do the financial markets tell us of the impact of Hurricane Katrina so far?

While the impact of Hurricane Katrina has certainly been devastating to the people of the Gulf Coast of the U.S., the financial markets are so far signalling that economic damage to the U.S. stemming from the event will be limited in the intermediate and long term. And that will hold true unless and until new information changes the view of the market.

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