Hurricanes katrina and Rita hit at a time when the U.S. economy was particularly vulnerable to a drop in consumer confidence.

Both consumer spending and the housing market have remained strong but are being financed by borrowing. The question is whether these hurricanes are the straws that will break the consumers’ backs.

Katrina didn’t just destroy a major city; it also knocked out oil and gas production, reduced refinery capacity and disrupted shipping on the Mississippi River, a critical route for grain, steel and other basic materials. Rita did further damage. After Katrina, refining capacity dropped by 11%; after Rita, 45% of refining capacity was closed down.

Most economists don’t expect a recession in the U.S., but the odds are rising. National Bank Financial Ltd. , for example, says the risk after Katrina was 25% and may now be higher. This scenario features a slowdown in economic activity as a result of shipping bottlenecks on the Mississippi. Combined with record high oil and natural gas prices this winter and continued increases in interest rates, this would lead to a deterioration in consumer confidence exacerbated by a slowdown in real estate activity, with price declines in some areas.

Consumers would respond with less borrowing, including mortgage refinancing, and increased savings. That would leave them without cash to spend, which would push the U.S. economy into recession.

U-shaped recovery

NBF’s baseline forecast is for U.S. growth of 3.5% this year and 3.4% in 2006. It expects a U-shaped (or slow) recovery from Katrina, featuring delays in commercial and residential rebuilding in New Orleans because of the need to de-contaminate certain areas and increase the city’s defences against another Category 5 hurricane.

In this scenario, oil and gas prices would remain above pre-Katrina levels, leaving consumers with less to spend on big-ticket items and other discretionary items. Under this scenario, the U.S. Federal Reserve Board would stop increasing its target rate at 4.25%, 50 basis points above the recent 3.75%.

On the upside, there is a 25% chance that there will be a classic V-shaped (or quick) recovery, says NBF. In this case, oil and gas production would be almost completely restored by yearends and prices would quickly return to pre-Katrina levels. This would keep consumer confidence — and spending — high.

In this case, economic growth would be so strong that interest rates would have to move to above 5% to prevent the U.S. economy from overheating. IE