Your move, Ben Bernanke
The economy grew at a slightly better-than-expected clip in the third quarter. But that probably won't cause the Fed to consider raising interest rates just yet.
NEW YORK (CNNMoney.com) -- Now that the economy has broken its four-quarter long slump, will Federal Reserve chairman Ben Bernanke be more open to the idea of raising interest rates sometime soon?
Don't bet on it.
The Fed's monetary policy committee is holding a two-day meeting next week that wraps up Wednesday. It is a virtual certainty that the central bank will keep the federal funds rate, its key short-term bank lending rate that affects how much consumers and businesses pay for various loans, near zero.
The big question though is what the Fed will say about the economy. Economists and traders will pore over the Fed's statement for any clues or hints that may suggest the Fed is getting closer to boosting rates again.
Since the Fed slashed rates to a range between zero and 0.25% last December, the central bank has maintained in each of its subsequent statements that "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."
So will Thursday's strong third-quarter GDP report change the Fed's thinking?
On the one hand, investments in housing and consumer spending were both up sharply in the quarter. That's a good sign considering that the real estate mess and pullback by consumers are two key factors that have held the economy back in the past year.
But at the same time, it's easy to look at the 3.5% annualized growth rate for GDP and dismiss it as nothing more than a one-time bump due to government spending -- a proverbial sugar rush.
"This changes nothing for the Fed," said Daniel Alpert, managing director with Westwood Capital, an investment bank in New York. "When you give blood, you usually give one pint. But the economy gave three. So the government gave us all lots of orange juice and cookies and Halloween candy to recover. That isn't going to continue."
This year's stimulus package, the popular Cash for Clunkers program and a tax credit for first-time home buyers all worked their magic on the economy during the quarter. But Cash for Clunkers is now history and the tax credit is tentatively set to expire at the end of November. Congress may agree to extend it though.
With that in mind, the Fed is probably not going to describe the state of the economy in glowing terms in next week's statement.
"The Fed has to wait and see. They don't want to make any knee-jerk reactions here -- particularly in light of the fact that the third-quarter GDP report might give a false sense of a robust recovery being underway,' said Sean Snaith, director of the Institute for Economic Competitiveness at the University of Central Florida in Orlando.
Of course, the Fed has to be careful to not keep rates this low for too long unless it wants to let an ugly inflation cat out of the bag.
Some economists are concerned that 0% interest rates, combined with the trillions of dollars spent on stimulus and financial bailouts, are setting the stage for a dramatically weaker dollar and high levels of inflation in the long-run. There are even Fed members, so-called inflation hawks, who have expressed worries about the risks of "exceptionally low" rates.
"Inflation risks are still very low," said Zach Pandl, an economist with Nomura Securities in New York. "But the GDP report will be an arrow in the hawks' quiver. It suggests that the economy is getting stronger and that inflation risks could crop up in the not-so-distant future."
For now though, Pandl said fighting future inflation should not be the Fed's most pressing concern. While the dollar has weakened as of late, helping to send the price of oil, gold and other commodities higher, the other tell-tale signs of inflation have yet to rear their ugly head.
Long-term bond rates are still relatively low, with the yield on the U.S. 10-year Treasury note hovering around 3.5%.
What's more, the job market is still in extremely poor shape. Economists are forecasting that the national unemployment rate will likely hit 10% before long. Inflation, more often than not, is a byproduct of a healthy labor market. Increased wages can set the stage for higher prices.
That's not happening now. So it's probably premature to fret too much about inflation before it's clear that the economy is really back on solid footing.
"There is no sustainable recovery without meaningful job creation," Alpert said.
Snaith agreed. He said that the Fed won't begin raising rates again until it is convinced that jobs are coming back. However, he said the central bank could begin to pull back further on its program of purchasing mortgage-backed securities as a way to make sure that "easy money" doesn't fuel another asset bubble.
The Fed has committed to buy $1.25 trillion of mortgage-backed securities and another $200 billion in debt issued by the government-controlled finance firms Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500) as a way to help keep mortgage rates low and support the housing market.
In September, the Fed said it will gradually slow the pace of these purchases and complete them by the end of the first quarter of 2010. Snaith said the Fed could give more details about an end to this so-called policy of "quantitative easing." But he thinks the Fed will be reluctant to do much more than that.
"The Fed doesn't want to nip this nascent recovery in the bud," Snaith said.
For that reason, Terry Clower, director of the Center for Economic Research and Development at the University of North Texas, said he hopes the Fed doesn't change much in its statement at all.
"Bernanke and others have been saying that it looks like the economy is growing again but they should just show guarded optimism. We're chugging along, just not at a really high level.," Clower said. "There are still significant risks to the downside."
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