Will the impact of Hurricane Katrina cause the

Federal Reserve

to pause its campaign of measured rate hikes?

The bond market is definitely starting to price in that possibility. Fed funds futures, which essentially are bets on where the central bank's key short-term rate will stand in the future, are still fully pricing in that the Fed will raise the rate by another 0.25% to 3.75% at its Sept. 20 meeting.

But expectations that the Fed will continue to hike beyond that have shrunk. Futures are now pricing that the rate will stand at 3.91% in November, at 3.98% in December, and at 4.02% in January. This means the market still believes the Fed will hike in November but is expecting it to skip a December hike.

"The Fed knows that the latest surge in energy prices could be the tipping point in consumer confidence," says Michael Gregory, interest rate strategist at BMO Nesbitt Burns. "We could now see consumers starting to save ahead of what's expected to be a heavy winter heating bill."

The stock market also has been assessing some of that risk, with prices dropping on Tuesday. On Wednesday, stock prices bounced back somewhat after the government announced it would open the nation's strategic petroleum reserves to provide crude oil to refineries. The news allowed crude oil to drop below $70 per barrel. The October contract was recently trading at $69.26, down 55 cents.

Major stock averages were recently mixed with the

Dow Jones Industrial Average

down 19.82 points, or 0.19%, at 10,393.00, but off a morning low of 10,356. The

S&P 500

was down 0.21 points, or 0.02%, at 1208.20, off a low of 1204. The

Nasdaq Composite

was up 0.54 points, or 0.03%, at 2130.30.

The benchmark 10-year Treasury bond was surging 20/32 in price, while its yield dropped to 4.02%, a three-month low.

In its latest assessment of the economy, seen Tuesday in the minutes of the Federal Open Market Committee's Aug. 9 meeting, the central bank said that inflation pressures had picked up recently because of surging energy prices. It only pinned risks to growth for next year.

But "in the context of the current environment, it appears that fighting inflation takes a back seat to fighting an energy shock that might lead to recession," says John Silvia, chief economist at Wachovia.

On Wednesday, Philadelphia Fed President Anthony Santomero said that Katrina would slow the economy, but that the current expansion is "strong enough to withstand" the impact. That should allow the Fed to continue raising rates at a "measured" pace, he said.

"The U.S. economy has proven to be surprisingly capable of absorbing such shocks, and after a short period, the effects of Katrina are likely to slow but not stall the forward progress of the national economy," Santomero said.

Santomero, who does vote on interest rates this year, said he still believes the U.S. economy will grow at a 3.5% to 4% rate this year. "If the economy evolves as I expect, then my sense is that the policy path upon which we embarked just over a year ago -- a movement toward neutral at a measured pace -- will continue to be appropriate," he said.

Of course, everything will depend on the assessment of the damages produced by Katrina's passage and its impact on the economy, which may take weeks.

Damage Assessment

The economic impact of Hurricane Katrina, likely to go down in history as one of the strongest storms to ever hit the country, is still hard to gauge. On the one hand, reconstruction adds to growth. But on the other hand, Katrina's impact on already soaring energy prices threatens to slow down consumption and overall economic activity.

The near-term impact of a storm is usually, and counterintuitively, positive for economic growth. Reconstruction efforts, funded by insurance companies and government aid, quickly find themselves boosting current production numbers, and therefore the national GDP.

In Katrina's case, total insured costs could go as high as $26 billion, while total damages are expected to reach close to $40 billion.

In addition, while New Orleans is a major port for imports and exports, disruptions to expensive oil imports to the U.S., which negatively hit trade numbers and therefore growth, could again counterintuitively be a net positive for the economy, according to Merrill Lynch economist Dave Rosenberg.

He expects the fallout from Katrina's passage to be slightly positive in the third quarter, adding a net of about $10 billion. Rebuilding, Rosenberg expects, will add about $40 billion to growth while "disruptions to the energy supply may boost prices long enough to act as a $30 billion drag on growth."

However, the positive brought by reductions in oil imports seems unlikely to be sustained for very long. Imports of crude oil are unloaded offshore from New Orleans and travel through the Louisiana Offshore Oil Port, or LOOP. As of Tuesday evening, local authorities estimated that the LOOP had sustained no severe damage.

And other economists, including those at Goldman Sachs, Wachovia and Action Economics, have a much more bearish assessment of the negative hit to growth from Katrina's devastation.

Goldman economist Bill Dudley believes that the quickly evolving developments in energy markets and Katrina's impact on the economy threaten his third-quarter estimate of 5% GDP growth (a fairly high estimate compared with other Wall Street economists). Dudley also based his revision on Wednesday's release of the preliminary second-quarter GDP.

The Commerce Department's preliminary reading on gross domestic product from April through June was revised downwards, coming in at plus 3.3% from the advance estimate of 3.4%.

Katrina's real drag on growth will come from its impact on both crude oil and gasoline prices, both of which have surged from already record-high levels since the storm caused oil production and refining facilities to shut down in the Gulf of Mexico and three southwestern states.

According to Action Economics chief economist Mike Englund, about a third of the petroleum produced in the U.S., which meets about 45% of U.S. demand, comes from the Gulf of Mexico, and about 90% of this production moves through Louisiana. So far, nine offshore rigs and 12 platforms have been evacuated, and refineries have been shutdown in Louisiana, Alabama and Mississippi.

Since Katrina hit the region, the impact on energy prices has been quick and amazing. Western Texas Intermediate crude oil is up almost 7%, heating oil for December delivery is up 7.5%, natural gas is up 11% and gasoline is up 7.4% from prehurricane levels.

At this early stage, Englund expects that the disruption of energy supply, even for just a few days, easily could cause a 0.2% subtraction from third-quarter GDP.

But it's still early in the game and "supply disruptions will have a price impact that could linger through the winter, given tight inventories of many refined products," and this should have a net negative impact on GDP growth over the quarters ahead, the economist says.

If this happens, and consumers do begin to restrain spending, a trend already seen in August as consumer confidence declined and

Wal-Mart

(WMT) - Get Report

warned of spending cutbacks -- a Fed pause will become increasingly likely.

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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