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A Bull Market for Uncertainty

In Katrina's wake, pressure builds on the Fed to pause its tightening campaign.
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The employment report released Friday has economists split over its relevance and its implications for monetary policy, given an uncertain economic outlook in the wake of Hurricane Katrina.

But while nobody really knows what Katrina's impact on the economy will be for weeks and perhaps months, it's likely that the

Federal Reserve

, faced with that uncertainty, will take a pause at its Sept. 20 meeting. "Why tighten if you are uncertain what the right move is?" writes Goldman Sachs chief economist Bill Dudley.

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Other economists, including Merrill Lynch's David Rosenberg, Morgan Stanley's Richard Berner and Naroff Economic Advisors' Joel Naroff, also believe that the odds of a Fed pause have substantially increased.

That also seemed to remain the assessment of the bond market Friday. Briefly dipping after the employment report, bonds later regained some lost ground. The benchmark 10-year Treasury bond was recently up 3/32 while its yield fell to 4.02%. The two-year note was flat while its yield, which most closely tracks the fed funds rate, stood at 3.72%.

Bonds have been rallying all week on expectations that Katrina's impact will force the Fed to soon pause in its year-long tightening campaign. On Thursday, hopes for such an outcome did not subside, even as President Bush, after meeting with Fed Chairman Alan Greenspan, told reporters that Katrina represents "a temporary disruption."

Stocks, meanwhile, meandered between similar expectations and concerns about the economy and profits going forward. Subdued action ahead of a three-day Labor Day weekend also kept a lid on prices. In recent trading, the

Dow Jones Industrial Average

was up 15.21 points, or 0.2%, at 10,474.84. The blue-chip average was lifted by the likes of

Caterpillar

(CAT) - Get Report

,

McDonald's

(MCD) - Get Report

and

Merck

(MRK) - Get Report

.

The

S&P 500

was recently down 0.68 points, or 0.1%, at 1220.91, while the

Nasdaq Composite

dipped 1.61 points, or 0.1%, to 2146.29.

The August employment report, meanwhile, showed that employment and the economy remained on a solid growth path ahead of Katrina.

August payrolls were a softer-than-expected 169,000 -- compared with expectations for a gain of 200,000 -- but upward revisions to the previous two months' numbers added another 44,000 payrolls.

Wage pressures remained contained in August, with average hourly earnings advancing a meager 0.1% in the month. But another upward revision to July's data brought the increase in the three months to August to an annualized rate of 3.3%, almost a three-year high. And the unemployment rate dropped from 5% to 4.9%, close to what many economists consider full employment, at which point wage-inflation pressures normally accelerate.

That was enough to convince Ian Shepherdson, chief U.S. economist with High Frequency Economics, that the Fed will continue raising rates. "Overall, the report shows the pre-Katrina labor market continuing to tighten, which is why the Fed will keep raising rates," he says.

That's also the assessment of other economists, including Lehman Brothers chief economist Ethan Harris. Furthermore, he says the bond market has missed the hawkish state of mind that the Fed was in before Katrina. The minutes of the Aug. 9 meeting of the Federal Open Market Committee, released Tuesday, showed the Fed had raised its expectations for core inflation given "the recent further rise in energy prices" and with revisions to previous data.

The Fed also raised its projection of economic growth for the balance of the year as data suggested "greater near-term momentum in aggregate demand."

Payrolls are expected to plunge in September, as employees in those regions of the three southeastern states hit the most by Katrina's passage are not expected to return to work anytime soon. Estimates range anywhere between a 500,000 to 700,000 drop in payrolls for next month.

But for Harris, this may prove temporary, and the fallout of Katrina's devastation may be just as inflationary as dampening to economic growth. Higher commodity prices, shipping bottlenecks and reduced local productive capacity all have the capacity to fuel inflation.

"As the government pours resources into the region and as residents draw on their savings to rebuild, aggregate spending will likely rise faster than the reduced aggregate capacity of the economy to produce," Harris says.

In its latest report on national employment, the outplacement firm Challenger & Grey said that the Bush administration will likely launch a reconstruction program similar to the Works Project Administration, created 70 years ago by President Franklin Delano Roosevelt during the Great Depression. "The WPA put thousands to work building schools, bridges, roads," says John Challenger, the outplacement firm's president. "The thousands of jobless and homeless in the Southeast could be employed to rebuild their cities under a similar program."

Still, there are many other challenges to national economic growth, not least of which is the price of retail gasoline surging above $3 per gallon in many parts of the country. "This will depress real consumer spending nationally until the refineries come back on stream and restore depleted gasoline inventories," says Goldman Sachs' Dudley. "This is a supply shock, and we view this as much more serious than a rise in energy prices caused by a rise in demand."

Crude fell 2.6% to $67.65 Friday on the New York Mercantile Exchange, which closed early for holiday observance. Gasoline fell 9.7% to $2.175 a gallon but still rose 17% this week.

Should a drop in consumer spending be large enough, it could create further job losses and push the economy into recession, Dudley warns.

Sept. 20, which is less than three weeks away, will likely be too soon for the Fed to have properly assessed any long-lasting impact from Katrina's devastation. The safest course would therefore be for the Fed to pause and adopt a "wait and see" approach, the Goldman economist says.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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