The FOMC is meeting on Tuesday, September 20 - only three weeks into the aftermath of Hurricane Katrina, one of the worst natural disasters to befall the United States. As bond investors were watching the horrific aftermath of Katrina, sentiment quickly developed in the market that the Fed would not continue their path of removing policy accommodation at a measured pace, that they will pause in raising the fed funds rate target. Given that the destruction caused havoc with oil refineries as well as shipping, Katrina is clearly having a national impact, not just a regional one. As a result, it isn't surprising that market players have come to the conclusion that the Fed would want to alleviate some of the negative aspects of the damage.

While I certainly can understand why Fed officials might consider momentarily pausing - it looks politically incorrect to raise rates as a large chunk of the country is suffering - it is not the Fed's job to provide emergency aid to a region of the country. Congress appropriated emergency aid that will go a long way into helping the evacuees and the region rebuild. Indeed, a lot of money is going into the region. Construction and rebuilding are already starting. Because the housing market was red hot before the rebuilding in the region, it is likely that price pressures will emerge for raw materials.

And of course, we have already seen prices jump for gas. Gasoline prices have risen by various degrees across the country. We've been relatively "lucky" in the Pacific Northwest with increases of "only" 25 cents before and after Katrina. However, the more densely populated eastern part of the country saw much larger gains. And while crude oil prices have come back down from their highs, gasoline prices have not fallen as much. Crude oil that is not yet refined doesn't help reduce gas prices.

Katrina exacerbated the problem, but gasoline has been rising for the past two years. Economists and policymakers don't believe that rising gasoline prices, on their own, cause inflationary pressures to worsen. However, pervasive increases in crude oil can spill over into prices of other goods and services. When the U.S. economy was in the early phases of its expansion, percolating inflationary pressures weren't much of a danger. However, economic conditions have been relatively good for the past couple of years and while we may not be exactly at full employment, we are much closer to a fully utilized economy than we've been for several years. As a result, the Federal Reserve must be more vigilant than ever to prevent inflationary expectations from developing and building.

This brings us back to next week's meeting. The Fed knows that it kept the federal funds rate target too low for too long. It has been striving to get back to neutral. Federal Reserve Chairman Alan Greenspan has finally admitted that the housing bubble could be dangerous. Before Katrina, getting back to a neutral Fed policy was aimed at alleviating price pressures and preventing the housing bubble from worsening.

Now, the Fed must keep in mind that Congress appropriated emergency aid that will allow construction and rebuilding in regions devastated by Katrina. Should the Fed also stop raising rates, there will be even more competition for scarce resources (raw materials). This would only cause more inflationary pressures. The Fed is the only entity that can alleviate inflationary pressures. If fiscal policy is highly accommodative - and it will be with all that federal aid and a burgeoning federal budget deficit - then the Fed will need to reign in some of the excesses by maintaining their course.

On Monday, Dallas Fed President Richard Fisher addressed the Texas Department of Banking Staff Conference. He touched on some key issues relating to Katrina. The excerpt below (in blue) is taken directly from his prepared remarks. And incidentally, he is not alone among Fed officials with these views. San Francisco Fed President Janet Yellen and Chicago Fed President Michael Moskow offered similar views last week.

National Economy: Clouded by Katrina
When I accepted your invitation to speak, we had no idea that we'd come together today in the aftermath of the worst natural disaster in modern American history. We have all seen the horrific images and heard the heartrending stories of the havoc wreaked by Hurricane Katrina in Louisiana, Mississippi and Alabama. The region's economy has taken a massive hit, with psychological and economic ripples spreading to the rest of the nation.

Before Katrina, the national economy was in pretty good shape, with most signs pointing to fairly strong growth. GDP had expanded by 3 percent or better for nine straight quarters. Aside from manufacturing, the job situation also looked bright. In August, nonfarm payroll employment totaled 135 million, up nearly 2 percent from a year earlier. The unemployment rate was 4.9 percent, the first reading under 5 percent in three years. Despite rising prices for oil, natural gas and other energy supplies, inflation remained relatively tame. And many companies ran up against constraints on their pricing power-the ability of companies to pass on higher costs for energy and other inputs to clients and consumers. Over the past year, the increase in the personal consumption expenditure index was 2.5 percent; excluding the volatile food and energy components, it was up 2 percent.

How does Katrina alter the outlook? The truth is, we do not really know. Two weeks after the hurricane, the economic repercussions are still sorting themselves out. We have only limited experience in seeing how a large, flexible and globalized economy like the United States' responds to massive disasters.

You might recall that a powerful earthquake struck Kobe, Japan's second largest port, in January 1995, causing $110 billion in damage to a city that handled 30 percent of the nation's trade. In addition to killing 5,500 and leaving 300,000 homeless, the quake destroyed 75,000 buildings and damaged another 200,000. It took two years to rebuild. The impact on the Japanese GDP, however, wasn't all that big. Despite having a major port out of commission, Japan's growth rate picked up as the year went on-going from 1.4 percent in the first quarter to 2.7 percent in the second and 4.6 percent in the third.

Every natural disaster is unique, and no two countries are the same. Japan's economy in 1995 was nowhere near as dynamic and flexible as ours is today. When it comes to Katrina and the U.S. economy, my inclination is to read, listen and watch and not rush to judgment about how the disaster will impact the economy or how monetary policy ought to respond. The hurricane's damages, as we all know, were significant in absolute terms-estimated at up to $200 billion. We've all seen television footage of thousands of destroyed and damaged buildings. Up close, it looks overwhelming. But it is important to bear in mind that Katrina's estimated physical losses amount to only a third of a percentage point of national wealth.

We have a huge economy-with nearly $40 trillion in wealth, production of $12 trillion a year and employment of 134 million workers. While Katrina's damage to Louisiana, Mississippi and Alabama is massive, the first-tier macroeconomic hit to the overall economy will be less so. We have all heard some projections for Katrina's impact on GDP and unemployment, but I hesitate to endorse any numbers. Early estimates are notoriously unreliable, and the media tend to highlight the most extreme. What's more, we tend to underestimate the inventiveness and cleverness of people and markets to respond to adversity.

It is clear, however, that a period of price volatility cannot be avoided for energy and other commodities processed, stored and transported along the Gulf Coast and the mighty Mississippi. The headlines have been full of news about gasoline climbing above $3 a gallon, although crude oil prices have already receded from their peaks. The massive effort to rebuild the Gulf Coast will create additional demand for lumber, steel, cement and other building materials. With so many prices in flux, our inflation measures will be tricky to read over the coming months.

While uncertainty surrounds Katrina's effects on economic growth and core inflation, one thing is clear: Congress and the executive branch are acting swiftly to provide emergency funding for the affected areas. So far, the federal government has authorized more than $62 billion for recovery efforts. I have asked my staff to carefully monitor this spending. Obviously, the political authorities, not the Federal Reserve, have the power of the purse. I pray they act wisely. With the nation's already large fiscal deficits, I personally believe it would be ill-advised for the Fed to monetize any fiscal profligacy.

Among the American economy's strengths are its size, diversity, interconnections and resiliency. I fully expect the economy to rebound from this disaster-as it did after the Sept. 11, 2001, terrorist attacks. And the Northridge, California, earthquake in 1994. And Hurricane Andrew in Florida in 1992. It will take time, of course, and we can never fully repair the damage done to individuals and families. Long ago, Thucydides might have anticipated the American sprit when he wrote: "We should remember that one man is much the same as another, and that he is best who is trained in the severest school." We Americans rise to overcome adversity and are at our finest when confronted with the severest challenges.

Bottom Line
Several Fed officials (bank presidents from the San Francisco Fed, the Dallas Fed and the Chicago Fed) all indicated that the Fed must closely monitor inflationary pressures. It is certainly possible that the Fed will go ahead and take a breather on their rate hikes next week. But I don't know that it is a done deal. Fed officials will certainly have more information than most of us given that the regional Fed presidents are in touch with businesses in the devastated areas. But it is telling that a number of key Fed presidents have already suggested that they must remain true to their mission - and worry about inflation first.

Evelina M. Tainer, Chief Economist, Econoday