NEW YORK (CNN/Money) -
Just a few days ago, several economists thought that the Federal Reserve would not need to change its plans for further interest rate hikes throughout this year despite Hurricane Katrina's impact on oil prices.
But as the news from Louisiana and Mississippi gets worse and worse by the day -- and gas prices continue to rise -- there is a growing sense that Alan Greenspan & Co. may have to pause sooner than they would have liked.
According to federal funds future contracts quoted on the Chicago Board of Trade, investors are now pricing in a fed funds rate of 3.67 percent by the beginning of October, which implies that another quarter-point hike by the Fed at its September 20 meeting, which would bring short-term rates to 3.75 percent, is no longer considered a certainty.
The Fed has already boosted the federal funds rate by a quarter of a percentage point ten times since June, 2004, lifting the benchmark short-term rate that banks use to determine overnight lending rates from a historical low of 1 percent to 3.5 percent.
Before Katrina, many market strategists and economists believed that the Fed would stick to its so called "measured" pace and raise rates by another quarter of a percentage point at each of its remaining three meetings this year in order to ward off inflation.
All bets may be off now though, given the disruptive effect that Katrina may have on the economy nationwide.
"It's too soon to tell whether they'll opt to pause, but the chances of that have increased significantly in the post-Katrina world," said Liz Ann Sonders, chief market strategist with Charles Schwab in a report Thursday. "Katrina may ultimately be defined as the 'crisis' that eased the Fed's foot off the monetary policy brake."
The bond market also appears to be betting on a pause. The yield on the 10-Year U.S. Treasury has slipped from 4.19 percent at the end of last week to 4.02 percent on Thursday. Falling long-term bond yields are typically associated with economic weakness.
Michael Cheah, manager of the SunAmerica GNMA and SunAmerica U.S. Government Securities fixed-income mutual funds, added that there is historical precedent for the Fed to change its plans in the wake of a disaster. The Fed cut interest rates in between scheduled meetings following the September 11 terrorist attacks four years ago and also did so after Hurricane Andrew ravished South Florida in 1992.
Cheah said he does not expect the Fed to lower interest rates since they are still relatively low. But he thinks that it would be wise for the Fed to stop in September.
"The Fed, like all good central banks, has to work on a real-time basis," said Cheah. "This is serious enough to cause a lot of pain."
As such, it might make sense for the Fed to err on the side of caution and hold off on raising rates in September, said David Resler, chief economist with Nomura Securities International. He argues that if the Fed paused in September, it could always boost rates again in November and beyond if it determines that the economy is not losing steam. Doing the opposite -- raising rates only to find out that the economy is in trouble -- could have disastrous consequences.
"If you tighten and a dire scenario is in fact unfolding, you've made matters materially worse," said Resler, adding that the "dire scenario" has to be considered an economic slowdown, not accelerating inflation as a result of rising oil prices.
...or not to pause?
But Tom Higgins, chief economist, with Payden & Rygel, a Los Angeles-based money management firm, still thinks that it's premature for investors to even guess about what the Fed will do because nobody really knows just how much of an economic impact Hurricane Katrina will truly have.
"The market is factoring in a higher probability of a pause now but it's absolutely too soon to tell," said Higgins. "By September 20, it may appear to be prudent to pause but the Fed will make the decision then depending on the severity of the economic damage."
Another economist said that the bond market's knee-jerk reaction to the hurricane -- i.e. that the Fed must pause -- could wind up being wrong.
"There's now a possibility of a pause whereas last week I would have described the thought as lunacy. But this does not necessarily portend a pause," said Chris Probyn, chief economist with State Street Global Advisors. "The Fed will be busy in the next two weeks to come up with as much hard information as to the size and duration of the hurricane effect."
To that end, Resler said it is difficult to determine how much of an impact Katrina will have on the national economy. On the one hand, he said that if oil prices remain persistently high for the next few months because of supply problems in the Gulf of Mexico, that could hurt consumer spending and possibly shave as much as a full percentage point off of gross domestic product (GDP) growth next year.
However, reconstruction efforts in New Orleans could also provide a temporary boost to the economy that could somewhat offset the effect of record-high energy prices.
"Higher oil prices may make growth weaker but since there is a need to rebuild a major metropolitan area as quickly as possible that could add to growth next year," he said.
With that in mind, Probyn thinks that what the Fed does in September is not nearly as important as what it does in November. He thinks that a pause in September might be a prudent thing to do to play it safe. But after that, the Fed should be in a position to decide whether or not to resume tightening or keep interest rates steady.
"This is a Fed that has demonstrated excellent crisis management skills," said Probyn. "But by the time we come to November, the Fed should be able to act with a greater degree of confidence. A pause in November would mean a severe downgrade in the prospects for the economy while tightening in November would show that the effects of Hurricane Katrina were probably temporary."
For more about Katrina's impact on the economy and markets, click here.
Is the Fed in for a crude awakening? Click here.