Housing woes can't derail economy

NEW YORK (CNNMoney.com) -- The U.S. economy shrugged off problems in the housing and credit markets in the third quarter, as the pace of economic growth showed an unexpected gain in the government's latest reading.

The government report Wednesday buttressed arguments on both sides of the question of the day: Should the Federal Reserve cut rates?

The unexpected strength reduced the need for the Fed to cut interest rates to combat fears of economic weakness. Yet a tame inflation reading in the report could give the central bank a green light to go ahead with a rate cut without worrying about spurring inflation.

Which side wins the debate will be revealed at 2:15 ET, when the Fed concludes its two-day meeting.

The gross domestic product, the broadest measure of the nation's economic activity, rose at an annual rate of 3.9 percent during the three months ended in September, according to the report.

That's up from the 3.8 percent growth in the second quarter. Economists surveyed by Briefing.com had forecast growth would slow to a 3.1 percent percent growth pace.

It was the strongest pace of economic growth since the first quarter of 2006, when the U.S. economy was catching up from the hit it took in the wake of hurricanes Katrina and Rita the previous quarter.

The report showed that consumption by individuals grew at a 3 percent annual rate, as consumers increased their purchases of most items other than autos.

Exports grew 16 percent, helping to add nearly a percentage point to the overall pace of growth.

The growth in business inventories added nearly 0.4 percentage points to the growth rate, which also was stronger than expected.

The report also showed that prices rose at only a 0.8 percent pace in the quarter, down from a 2.6 percent increase in the second quarter. Economists had forecast that measure, known as the GDP price deflator, would slow to a 2 percent rise in the latest reading.

An even more closely watched inflation measure known as the core PCE deflator, which measures prices paid by consumers for goods other than food and energy, rose at an annual rate of 1.8 percent. That's more than the 1.4 percent increase in that reading in the second quarter. The Fed is believed to want to see the core PCE reading between 1 to 2 percent.

In a separate government report, the Employment Cost Index rose 0.8 percent in the third quarter compared to the previous three months. That's down from the 0.9 percent rise in the second quarter. Economists had been looking for another 0.9 percent increase in the third quarter.

The readings on both economic growth and price pressures were being closely watched for clues as to what the Fed might do with interest rates. Most economists are forecasting the central bank will trim rates by a quarter-percentage point.

At its Sept. 18 meeting, the central bank cut rates by a half-point, its first cut in four years, as it cited the threat to the economy from problems in housing and credit markets.

David Wyss, chief economist for Standard & Poor's, said he had thought there was about a 67 percent probability of a quarter-point rate cut. But the strength shown in the GDP report makes him think the chance of a cut was no better than 50-50, and maybe a bit less than that.

"If I was on the Fed, it would be a reason to sit back and wait to see what happens next," said Wyss. "But remember, this is history, not the future. We always thought the weak quarters would be the fourth and first quarters."

Wyss said the tame price readings could let the Fed go ahead with a rate cut without the fear of inflation heating up. The fact that investors have strongly signaled that they expect a rate cut could lead the Fed to go ahead and reduce rates, he said.

"If this cut wasn't already in the market, I doubt they would even think about cutting," Wyss said. "My guess is they still go with the quarter point, but I'm not certain."

But John Silvia, chief economist with Wachovia, said that the stronger than expected economic number is not reason for the Fed to pause and leave rates unchanged, given the problems in housing and the credit markets.

He pointed out that even though housing and home building had already slowed significantly in the first half of the year, the investment in housing was an even greater drag on the economy in the latest report, not a smaller drag as he and other economists had forecast.

"The risk there is the problems in housing and mortgages fester and spread throughout the economy," he said. "That's what the fed has to be concerned about."

Silvia said that most economists missed the pickup in economic growth for three reasons. First, they were expecting a higher rate of overall prices, which would have left the GDP number lower, since it measures real growth, adjusted for inflation. Second the report showed slightly stronger than expected exports, which was helped by the weaker dollar in the period, which makes U.S. goods more competitive. And third a build-up in business inventories lifted economic activity more than expected.

None of those factors suggest that the economy is in danger of overheating and raising inflation, Silvia argued. So the Fed can cut rates again without worrying about prices getting out of hand.

"The low deflator number gives the Fed a lot more room to work with," he said. "They're looking at a fourth quarter where you don't get some of these jumps, along with weaker consumer spending. You still have the issues in housing and credit markets."