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Partying like it's 1999 -- into 2006
Economists raise forecasts after stellar GDP report, but some worry about a more aggressive Fed.
November 30, 2005: 4:40 PM EST
By Chris Isidore, CNNMoney.com senior writer
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NEW YORK (CNN/Money) - Growth without inflation ... for economists and policymakers, it's like getting to have dessert for breakfast, dessert for lunch, followed by more dessert for dinner.

And that's what was served in the government's report on third-quarter economic growth released Wednesday.

Gross domestic product grew at a 4.3 percent rate in the third quarter, a full percentage point faster than second-quarter growth and tied for the second-best reading since the second quarter of 2000, when the Nasdaq market peaked at the height of the tech bubble.

The economy's third-quarter performance came despite Hurricane Katrina, an oil price shock and record trade deficits, all of which put brakes on growth in September. And it did this with core inflation staying in check, with business investment gaining and consumer spending staying strong despite the obstacles.

All of that led many economists to be pleasantly surprised Wednesday, and to grow more optimistic about the future. While most say the third-quarter growth rate is unsustainable, they also expect solid growth of 3 to 3.5 percent going through the first half of 2006.

"I deal in a world when there's a lot of economic tensions going on, then I get a report like this that is all cake and ice cream," said John Silvia, chief economist for Wachovia Securities. Silvia said his group will probably raise its forecast for the fourth quarter to growth at a 3.3 percent rate, from its earlier target of 2.8 percent.

Other economists were upping their fourth-quarter forecasts even higher, noting the third-quarter reading meant the economy had plenty of momentum heading into the all-important holiday shopping period.

"I think it's going to be a good holiday season, although after that I think after that we're going to see something of a hangover," said Jeoff Hall, chief U.S. economist for Thomson Financial, who plans to raise his fourth quarter estimate of GDP growth to about 3.8 percent from 3.5 percent.

"But what I'm seeing in terms of capital investment is very constructive. I think business spending is set to do some heavy lifting even if consumers pull back," he added.

Still, some worries

The concern for economists (and they wouldn't be economists if they weren't still concerned) center around how high the Federal Reserve might now have to raise interest rates in a bid to make sure the economy doesn't get too hot and stoke inflation.

Another concern: How much will consumers pull back if the white-hot housing market has already reached its peak, as most real-estate economists and reports say seems to be happening.

As to the Fed, most economists had expected the central bank to stop raising rates when its fed funds rate hit 4.5 or 4.75 percent, which would be either two more quarter-point increases or perhaps three if Fed Chairman nominee Ben Bernanke boosts rates again at his first meeting in March. Bernanke is due to take the helm at the Fed Feb. 1, assuming the full Senate approves his nomination, which is widely expected.

But some said that if the economy stays hot, the Fed will have to keep boosting rates in order to ward off inflation, which could make a so-called soft landing for the economy -- slower growth but not a recession -- more difficult.

"If we get more numbers like today's GDP number, they are going to have to go to 5 or 5.5 percent," said Silvia. "That would be a tricky situation for us."

Drew Matus, senior economist at Lehman Brothers, said his concern is that the economy can't stay this hot without a growing inflationary threat.

He was already predicting 4 percent growth in the fourth quarter even before Wednesday's report and he's leaving that bullish forecast in place, while watching for signs that higher energy prices are putting upward pressure on prices.

"We'll see how and when energy prices feed through into the core [inflation] rates," he said, adding, "anecdotally, there's a lot of evidence that's starting to happen and that there's an undercurrent of inflation risk beginning to build."

Matus expects the Fed to raise rates through the March meeting but said the central bankers may keep raising rates beyond that.

"It [inflation risk] suggests the Fed will have to keep pushing the brake. That could dissipate some of the growth," he said.

But other economists say that even with strong growth, the Fed can afford to pause in its path of measured rate hikes early next year due to what they see as a modest inflationary outlook coupled with the lagging impact of the central bank's earlier rate hikes.

"We've backed out of the worst of the energy price effect," said Thomson Financial's Hall. "I think there are inflationary pressures, but I consider them a low level threat right now."

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For a look at the third quarter GDP report, click here.

For a closer look at economic readings affecting you and the markets, click here.  Top of page

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