by Nigel Gault
Hurricane Katrina has dealt a devastating blow to the Gulf Coast and to the city of New Orleans in particular. We do not expect it to derail the national economic expansion, though. It will put a dent in growth during the second half of 2005, but we expect that to be offset by faster growth in 2006 as reconstruction activity accelerates. We have reduced our 2005 GDP growth forecast from 3.7% to 3.5% and raised our 2006 growth forecast from 3.2% to 3.4%. This view assumes, importantly, that the worst is over in the energy sector, and that gasoline prices will soon be heading back below $3 per gallon.
The Hurricane's Toll. Katrina is the costliest natural disaster ever to hit the United States. Current estimates put privately insured damage as high as $35 billion (0.3% of GDP). Add on uninsured damage, the loss of public infrastructure, and the cost of public relief efforts, and the total costs will run into hundreds of billions. Hurricanes destroy wealth—but rebuilding that wealth creates activity. The scale of Katrina's destruction means that the boost to growth will take longer than usual to come through, but it will be evident in 2006.
Slower Growth in the Second Half of 2005… We have reduced our projected GDP growth rates for the second half by an average of 0.7 percentage point. Normal activity has been disrupted, most severely in flooded New Orleans. In addition, the surge in gasoline and natural gas prices will squeeze consumer incomes, and we expect consumer spending growth to slow to 0.8% in the fourth quarter, from 3.9% in the third quarter. Katrina intensifies a slowdown that we had already anticipated as a payback for the incentive-induced surge in vehicle sales during the third quarter.
…But a Pickup in the First Half of 2006. By the first half of next year, energy output will be higher, gasoline prices should be lower, and reconstruction activity will be gathering momentum. The rebuilding of New Orleans will be a multi-year project, but reconstruction should proceed more quickly in the rest of the affected region. In the first half of 2006, we now expect growth averaging 3.8%, 0.8 percentage point faster than in our previous forecast. Residential and nonresidential construction and public infrastructure are the main beneficiaries.
Energy: Is the Worst Over? Katrina shut down roughly 10% of US refining capacity in an already-stretched system, sending retail gasoline prices soaring above $3 per gallon. The "good" news is that refining capacity is now starting to come back on line and that more gasoline imports are on the way. We anticipate that the retail gasoline price will fall back to around $2.50 by year-end. Our oil price forecast assumes a WTI price in the $65–67/barrel region for the rest of 2005, falling back gradually to $54 by the end of 2006. The risks around this forecast are skewed to the upside, though, given the danger of other supply disruptions in an already tight market.
Bond Yields Expected to Rise. Ten-year bond yields fell back to around 4% as markets scaled back their expectations for Federal Reserve rate hikes. We believe that—even if the Fed does pause—it has more work to do than the markets expect. Therefore, Global Insight expects yields to reverse course and head up toward 5% during 2006.
Fed Rate Hikes May Pause—But Not For Long. We assume that the federal funds rate is held at 3.50% for two meetings to allow the post-Katrina picture to become clearer, but that the Fed resumes its rate hikes in December as it becomes evident that the economy has passed the worst of the disruption and is gearing up for faster growth in 2006. We still expect the funds rate to reach 4.50% in 2006. Katrina may cause a detour in the rate's path, but we do not believe it will change the final destination.
