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How Will the Fed React to Sandy?

Brendan Smialowski | AFP | Getty Images

There's already talk on Wall Street about the possibility of the Federal Reserve providing further monetary accommodation in response to the damage wrought by Sandy.

With the Fed Funds target rate at zero, this could mean larger quantitative easing asset purchases or a focus on buying different financial assets by the Fed.

One trader even described what he thinks the Fed will do as "QE Sandy."

If history and economic theory are guides to Fed policy, however, those counting on further accommodation may be in for a shock. It's very possible—even likely—that Sandy will mean Fed policy might be tighter than it might have otherwise been. And that's because Sandy's side-effects might well accomplish the very things that Ben Bernanke has been hoping that his quantitative easing policy would.

The reason why some of the guys in expensive shoes who are telecommuting this week into Wall Street investment banks might expect further easing is obvious. The economy has experienced a real shock, losses will be in the as-yet-untold scores of billions. Federal and local governments will accelerate spending to provide relief and reconstruction. Economic activity in the Northeast has been severely disrupted. The economy obviously needs an injection of money.

Only that may not be the way the Fed sees it.

In the aftermath of hurricane Katrina, there were widespread expectations that the Fed would drop its interest rate targets. Economists, who had expected a tightening of policy before the hurricane struck, flipped to predicting easing. The Fed funds rate began dropping in anticipation of a falling target rate.

And then the Fed raised the target rate on September 20, 2005.

An economics paper published three years after this episode of contrarian Fed action explained not only why the Fed took this action—but why "the monetary authority should raise its nominal interest rate target following a disaster."

(Read More: Scenes From Hurricane Sandy)

The paper, "Natural Disasters and Monetary Policy is a DSGE Model" by University of Oklahoma's Benjamin Keen and University of Arkansas at Little Rock's Michael R. Pakko, is written in the usual economic hieroglyphics. But if you look beyond the equations, the argument is easy enough to follow.

Click here for Link for paper

A natural disaster destroys existing capital stock and disrupts production. As a result, firms lower their output and raise their prices. That is, inflation follows disaster. Not all firms can adjust prices, of course, so they try to compensate for lost productivity and lost capital stock by increasing their labor, resulting in increased hiring.

Here's how that plays out:

In the period after the disaster, the return of productivity to its pre-disaster level permits firms to increase output, which lifts households' income and enables them to increase their investment in physical capital. That process continues for a number of periods as the capital stock is slowly reconstructed. In the longer term, the protracted rebuilding of the capital stock is associated with below-trend output and persistent, above-trend paths for employment, investment, and inflation.

In a well-functioning economy, this would be a recipe for higher rates. But our problem lately has been too much unemployment and inflation rates that stubbornly stay below target. So the most likely effect of Sandy now isn't higher rates. But Sandy may help the Fed move closer to its economic goals with less QE than it otherwise might have employed.

Updated to reflect this date change: The Fed raised the target rate on September 20, 2005.

(Read more: Sandy Wreaks Havoc, Economic Impact Not Yet Clear)

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