US to grow by 7%, interest rates at 1%, so....

The highlight of this week's data will be the first estimate of third quarter growth in the US, released on Thursday. We are looking for growth of around 7%. This is an annualised figure based on no more than two months data, so it is as much a guess as a forecast. It could easily be 1% either way. But anything in this ballpark would clearly be very strong.

There should also be at least two positive points in the breakdown. The first is that inventories are still likely to be subtracting from growth. This is important, because it will show that the economy is growing strongly even before the inventory cycle has turned positive. The inventory cycle should therefore help to sustain growth in 2004 once the current stimulus from temporary factors - tax cuts and mortgage refinancing - starts to fade.

The second is business investment. One of the things that many people believe, but the data simply does not support, is that companies will not invest when capacity utilisation is low. In reality, corporate profits are surging, business confidence is recovering and even at low levels of capacity utilisation, existing capacity still needs to be updated. Spending on equipment and software rose at an annualised rate of around 6% in Q2. In Q3 this figure could be more than 10%.

Of course, GDP growth of 7% cannot be sustained. (It is amazing how many people think that is an insightful statement!). Growth will inevitably slow in Q4 (probably to around 4%) and beyond. But the best leading indicators suggest that a growth rate of 4% can now be sustained for several quarters.

The FOMC meeting on Tuesday will therefore be one of the most interesting for a long time. Interest rates will be left unchanged. But the accompanying statement could prove to be an impossible balancing act.

The problem is this. The Fed will want to keep its easing bias this week and signal that rates will remain low for a considerable period. However, it cannot just repeat the language from the September statement. The minimum change would be an acknowledgement that the labour market has begun to recover, following the first month-on-month rise in payrolls.

The biggest difficulty is the language on the bias. Remember this is now split, partly to justify keeping rates so low when the economy is rebounding. The risks to growth are now said to be balanced, whereas the risks to inflation are still on the downside. Both assessments are increasingly hard to defend. Indeed, the first may be impossible. Given the prospect of 7% growth in Q3 and 4% (still above trend) thereafter, the Fed surely cannot continue to say that the 'the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal'.

Nonetheless, the Fed will bend over backwards to retain an overall 'easing bias' this week. To make this credible, they would have to retain the downside bias on inflation and argue that this bias is strong enough to offset the emerging upside risks to growth. This is just about defensible now, given that output is below trend and the help to unit costs from rapid productivity gains may last a quarter or two yet. But with the recovery gathering pace and the dollar weakening, the bias will have to shift back to neutral soon. We think this should happen in December, with a tightening bias returning in Q1 next year.