WASHINGTON -- Bond market expectations of another round of credit-tightening by the Federal Reserve were reinforced after the government reported on Friday that the economy grew a healthy 3.4% in the third quarter.
Analysts said a move by members of the Federal Open Market Committee to raise short-term interest rates to 5.25% from 4.75% when they meet Nov. 15 is now a virtual certainty.
In an interview last week, Fed vice chairman Alan Blinder said he was surprised by the economy's continuing strength despite the Fed's five moves this year to raise rates. Richmond Federal Reserve Bank president J. Alfred Broaddus made similar comments.
The 3.4% rate of growth in the Commerce Department's advance estimate marked a mild deceleration from the 4.1% pace recorded in the second quarter. Fed officials have indicated they would like to see growth of around 2.5% to contain the threat of higher inflation.
Inflation in the third quarter remained subdued, according to the Commerce Department report. The GDP fixed-weight price measure rose only 2.7%, and the implicit price deflator was up only 1.6%.
But analysts said Fed officials are under pressure to respond to the bond market's expectations of another dose of credit-tightening to slow the economy.
"I think there's a feeling the Fed has fallen behind the curve," said C. Douglas Lee, chief economist for NatWest Markets. "They got started early in raising rates, and that was fine, but now the economy hasn't slowed down in the second half of the year in a persuasive way. If they don't raise rates in mid-November, the embers will react negatively."
William B. Hummer, president of Wayne Hummer & Co. in Chicago, agreed. "There is a very widespread conviction that the economy is nearing its capacity limits both in terms of plant and manpower," he said.
Last week the Labor Department reported that wage increases remained mild in the third quarter. The employment cost index showed total compensation paid by businesses rose at an annual rate of only 3.2%. Contract wage settlements by organized labor were reported to be small.
But analysts continue to believe that with a strong economy operating close to full capacity, it is only a matter of time before inflation turns up at least mildly. Moreover, inflation statistics are widely viewed as a lagging indicator -- not a sign of what lies ahead.
A decision by the Fed to tighten policy will be based on the recent resurgence in commodity prices, a weak dollar in the foreign exchange market, and the economy's "intense level of resource utilization" as measured by the jobless rate and the factory operating rate, said analysts at Donaldson, Lufkin & Jenrette Securities Corp.
In an interview on CNBC, White House chief of staff Leon Panetta hailed the GDP report as more evidence that the economy is doing well. "I don't think you could ask for a better set of number," he said.
Meanwhile, the Conference Board said its latest forecast calls for the economy to remain strong and grow by 4% in 1995 even with another move by the Fed to raise rates next month. Gail Fosler, the business research group's chief economist, said growth is being fueled by rapid gains in income and stepped-up borrowing by consumers and business.
However, some economists said the Fed's policy of raising rates is likely to start taking hold soon and slowing growth. They noted that some of the gains in third-quarter GDP came from another huge rise in business inventories and an unexpected surge in government outlays.
"With higher inventories and higher interest rates setting in, we're likely to see a slower economy in the current quarter," said Robert D. Barr, deputy chief economist for the U.S. Chamber of Commerce.
'It looks like the business attitude toward inventories has switched from just-in-time to just-in-case," Lee said. He cautioned that if business cut back on inventories and consumers stay away from the stores after Christmas, there could be "a sharp change, a slowdown early in 1995."