By John W. Schoen Senior producer
msnbc.com
updated 10/24/2006 5:07:38 PM ET 2006-10-24T21:07:38

While economists, investors and other Fed watchers agree the central bank is committed to leaving interest rates right alone for now, there’s a lot less agreement on what comes next.

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Until recently, the conventional wisdom held that the central bank's recent pause — after two years of steady rate increases — meant that the next move, whenever it comes, would be to cut rates. Most Fed watchers believed that a slowing economy, led by a limping housing market, should help ease the Fed’s perennial worries about inflation and rates cuts would follow, probably sometime next year.

But with inflation still well above the central bankers’ comfort zone, the prospect of a rate cut by the Federal Open Market Committee, which began its latest two-day session Tuesday, seems to be moving further into the future.

“The economy is slowing, but the inflation data has still been stubborn and that's sort of a recipe for stagflation,” said Phil Orlando, chief equity market strategist at Federated Investors. “Right now we think the Fed is on hold, but we think that the people that expected the Fed to start cutting maybe by the end of this year, beginning of next — they may be a little disappointed."

Some now believe the next move may be upward, especially if a slowing economy doesn’t bring inflation down. Donald Straszheim, a long-time Fed watcher now at Roth Capital Partners, is among those who think the odds favor an increase in rates, which he says “the markets won’t like.”

For now, Fed officials have been content to rely on public statements — rather than actual rate moves — to try to keep a lid on inflation.

"The inflation outlook remains highly uncertain," San Francisco Fed President Janet Yellen said this month. "And until we actually see inflation begin to slow down, I will be focused on the upside risks in the outlook."

By talking tough, the Fed helped spark a recent bond market rally. (As market interest rates have fallen, reflecting investors' diminishing concern about inflation, bond prices have risen.) That, in turn, has helped prevent rising long-term rates from slowing the economy further, allowing the Fed to sit on its hands and do nothing.

"The FOMC can some of the time — maybe even much of the time — sit back and do relatively little, relying on the stabilizing effect of market reactions to current data. We don't have to do it all," William Poole, president of the St. Louis Fed, said this month. "The decline in long rates is working as a built-in stabilizer for the economy."

But there are limits to what the Fed can do with speeches. For one thing, the bond market —not the central bank — determines the course of long-term interest rates. And the Fed’s current “wait-and-see” policy on short-term rates is made easier if the economy eventually makes a hoped-for “soft landing.”

"(They) would like to jawbone the market as much as they can, so they have to use the actual interest rate policy as little as necessary," said Gregory Miller, chief economist with SunTrust Banks. "(But) there's also the prospect that real growth could deteriorate more dramatically than the Fed is currently anticipating."

The answer may begin to show up in economic data due out this week. A report on sales of  existing homes in September is due out Wednesday, with data on new home sales due Thursday. And on Friday, the Commerce Department releases its first estimate of third-quarter gross domestic product, which economists expect to come in at 2.2 percent, down from 2.6 percent in the second quarter and 5.6 percent in the first quarter.

Even as the economy slows, the committee made clear in the minutes of its Oct. 11 meeting that it is still worried that inflation is too high. Stronger-than-expected growth could add to those worries. After a long slumber, the recent stock market rally is riding a healthy pickup in corporate profits.

“We have companies doing all of the right things right now,” Brent Wilsey, a San Diego-based money manager, told CNBC last week. “They are buying back stock, reporting good earnings and mostly good forecasts going forward and paying out good dividends.”

Bulls like Wilsey think stock prices still have some catching up to do; he thinks the Dow is headed for 13,000 by April. But that remains to be seen.

"When you look at some of the bullish forecasts that are out there, you're kind of extrapolating out that the current earnings pace is going to continue for the next 12 to 18 months," said Bryan Piskorowski, a market analyst with Wachovia Securities.

Reuters and CNBC contributed to this story.

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