The U.S. economy has proven to be very resilient to all sorts of shocks over the past several decades. In part this reflects the fact that not all sectors of the economy move together, and a decline in one sector does not always imply major problems in the economy as a whole. The economy withstood Hurricane Katrina, oil shocks, and 9/11 with remarkable resiliency.

For instance, in the wake of Hurricane Katrina in late 2005, markets’ immediate response to rising energy prices suggested expectations of persistently rising inflation. Market participants, it seems, were uncertain as to how much of a run-up in general inflation the Fed would allow. Inflation expectations moved back down after a number of FOMC members made speeches emphasizing their focus on preserving low inflation. This episode illustrates both the potential for the Fed to influence inflation expectations and the extent to which market participants are at times uncertain as to how the Fed will respond to new developments.

If we are at all accurate, 2006 will be a year of solid growth, perhaps faster in the first half as Katrina rebuilding occurs and energy prices stabilize, and slower later on as hurricane-related fiscal stimulus ebbs and housing activity tapers off, but strong overall.

My best guess is that a good part of this strength is the flip-side of the factors that made the economy weak in the fourth quarter, and therefore should not be extrapolated to subsequent quarters. Therefore, it seems likely that growth will settle back to a trend-like pattern as the year progresses. One likely contributing factor is the winding down of the rebuilding effort later in the year. Another is the lagged effect of monetary policy tightening; in other words, tighter financial conditions will have a dampening impact on interest-sensitive sectors, such as consumer durables, housing, and business investment.

The hurricanes left an imprint on aggregate economic activity as well, seen, in part, in the marked deceleration of real GDP in the fourth quarter. However, the most recent evidence--including indicators of production, the flow of new orders to businesses, weekly data on initial claims for unemployment insurance, and the payroll employment and retail sales figures for January--suggests that the economic expansion remains on track.

Real economic activity has continued to expand at a solid pace. Clearly, the tragedy that hurricanes inflicted on New Orleans and surrounding areas of the Gulf Coast will have major implications for the people and the economy in those regions for a long time. However, for the nation as a whole, employment and industrial production indicators were only briefly disrupted by the hurricanes during the late summer and early fall.

In the immediate aftermath of Hurricane Katrina, fears were widespread that consumers might pull back sharply on spending, both in response to sharply higher retail gasoline prices and out of a general sense of heightened anxiety about potential fallout from the storm damage. Survey measures of consumer confidence, which plummeted in September, seemed to bolster this view. But the effect of the storms on consumer outlays have turned out to be far more limited than expected, exemplifying the oft-cited resilience of the U.S. economy.

Immediately following Hurricane Katrina, as the magnitude of the effects on Gulf Coast energy production became clear, many observers came to fear that the resulting sharp increase in energy prices might lead to a broader increase in inflation, and perhaps even recessionary forces. These observers appeared to be reasoning by analogy to the 1970s, but I believe that analogy is mistaken. Inflation expectations were unanchored in the 1970s, the credibility of the Federal Reserve was low, and people expected the Fed to allow energy price shocks to feed through to overall inflation. The Fed often accommodated that expectation by preventing short-term real interest rates from rising. In fact, at times we kept nominal rates from rising as fast as inflation and thus provided further monetary stimulus. The Fed was then forced to raise rates dramatically to bring inflation back down, and in the process induced an economic contraction, exacerbating the real effects of the oil price shocks. Thus, the proper lesson from the 1970s is not that energy price shocks induce major recessions or cause widespread inflation; it is that monetary policy that reacts to energy price shocks by accommodating the rise in inflation can induce major recessions. Monetary policy should respond to energy shocks by remaining focused on price stability. That way, the economy can respond to energy price shocks the way it should — the relative price of energy increases, but core inflation remains anchored.

The U.S. economy has delivered a solid performance thus far in 2005. And, despite the disruptions of Hurricanes Katrina, Rita, and Wilma, economic activity appears to be expanding at a reasonably good pace as we head into 2006. However, the positive short-term economic outlook is playing out against a backdrop of concern about the prospects for the federal budget over the longer run. To be sure, the current pace of the ramp-up in spending on defense and homeland security is not expected to continue indefinitely. But, as the latest projections from the Administration and the Congressional Budget Office suggest, our budget position will substantially worsen in the coming years unless major deficit-reducing actions are taken.

Signs point to another robust performance in the fourth quarter, so growth for the last half of 2005 could well come in noticeably above the potential rate.  This positive performance suggests that the overall economy has been quite resilient in absorbing the impact of the storms [Hurricanes Katrina and Rita].  For 2006, it seems likely that this strength will continue in the first half, as rebuilding kicks in.  Then, in the second half, a couple of factors are likely to cause economic growth to settle into a trend-like pattern.  One of the factors is the winding down of the rebuilding effort.  The other is the lagged effect of monetary policy tightening; in other words tighter financial conditions will have some dampening impact on interest-sensitive sectors, such as consumer durables and housing.

Recently, Hurricanes Katrina and Rita slowed economic growth. Clearly, the storms were devastating in terms of lost lives and property destruction, and they created large losses for the local economies. For the national economy, however, it appears that the negative effects of the hurricanes are limited. Furthermore, rebuilding efforts will boost economic activity. 

For the national economy...it appears that the negative effects of the hurricanes are modest. Furthermore, rebuilding efforts will boost economic activity.

The disruptions to energy production have noticeably affected economic activity. We estimate that the storms held down the increase in industrial production 0.4 percentage point in August and an additional 1.7 percentage point in September. Except for the hurricane effects, readings on the economy indicate a continued solid expansion of aggregate demand and production. If allowance is taken for the effects of Katrina and Rita and for the now-settled machinist strike at Boeing, industrial production rose at an annual rate of 5-1/4 percent in the third quarter. That's up from an annual pace of 1-1/4 percent in the second quarter.

The federal budget situation [was]--at least until Hurricanes Katrina and Rita struck the Gulf Coast--...showing signs of modest improvement...Lowering the deficit further in the near term, however, will be difficult in light of the need to pay for post-hurricane reconstruction and relief. But even apart from the hurricanes, our budget position is unlikely to improve substantially further until we restore constraints similar to the Budget Enforcement Act of 1990, which were allowed to lapse in 2002. 

Fundamental to our economic strength has been the pro-growth policies the President has championed. Lower tax rates for all taxpayers put money back in the hands of consumers. An increase in expensing for capital investment gave a boost to small businesses. It's important to continue this growth that we make the tax cuts permanent.  It is also important that we exercise fiscal discipline. The increased spending required for hurricane recovery efforts make this all the more important. We are currently on the path to cut the federal deficit in half by 2009, and while economic growth has helped the growth of Treasury receipts quite a bit, spending restraint is the necessary other-half to the deficit-cutting process.