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Fed Likely to Hold Rates Steady, But Many Wonder What's Next

Fed watchers are already looking past Tuesday's meeting and wondering what the central bank has in mind for next year.

Federal Reserve policymakers are widely expected to hold interest rates steady at 5.25% for the fourth consecutive time. More important will be clues the central bank gives about its intentions for next year. The Fed announcement will be at 2:15 pm New York time.

"I think the bigger question really is: How does the Fed sound early next year?" said Jason Trennert, chief investment strategist and managing partner at Strategas Research Partners LLC on CNBC's "Power Lunch."

Up until now, the Fed's stance is that the economy remains on solid ground, with inflation being the biggest risk to economic health.

"I think the Fed has a story, and they want to stick to it," said Steve East, FBR Chief Economist, who also appeared on "Power Lunch." "The best way they can let the markets know they have a story and are sticking to it is to not change their statement tomorrow."

Expand at "Moderate Pace"

The last time policymakers met, on Oct. 25, the Fed said the economy had slowed "partly reflecting a cooling of the housing market" and that "going forward, the economy seems likely to expand at a moderate pace."

Since then, the economic data has been generally supportive of this statement. A decline in housing starts has shaved growth off many economists' estimates for gross domestic product growth.

More recent comments from Fed officials, including Chairman Ben Bernanke, suggests this view hasn't changed. This viewpoint was further supported by last week's November payroll data, which painted a picture of a tight labor market.

"I wouldn't be surprised to see a statement that is pretty identical to last time," said Former Richmond Fed President Alfred Broaddus on CNBC's "Street Signs."

"The inflation number is still holding up there, and that is something that needs to be watched," Broaddus said.

Many suspect that as long as the Fed sees inflation as a problem, officials will retain their bias toward further interest rate hikes.

However, Broaddus admitted that several pieces of data have shown signs of weakening in the economy. He specifically cited softness in consumer spending and the auto sector.

Others point to a contraction in the Institute for Supply Management's manufacturing index.

Employment Still Strong

"The one exception is the labor market," Broaddus said. "It was a strong and solid report, but that report tends to lag the economy."

With the data sending mixed signals, it is no surprise that there are so many diverging views on where the economy is heading. To some extent, it depends on which pieces of data economists are focusing in on to make their assumptions.

Strategas' Trennert said he doesn't expect inflation can be a problem if the labor wage inflation remains in check.

"If you're measuring it using the employment cost index, which includes benefits, it is still very much under control," Trennert said. "I think bond yields are basically telling you that inflation isn't much of a problem. So I'm not too worried about inflation. I am more worried, frankly, about GDP growth."

Opinions seem to be diverging wildly on this topic.

J.P. Morgan Chief U.S. Economist Bruce Kasman expects GDP growth to move back up to 3% within the next few months. He expects the housing drag will have largely vanished some time over the next six to nine months.

"If the Fed is looking at the world now, housing weakness is clearly a big factor," Kasman said. "But if we move out six to nine months, and if we're right that the economy does OK, I think inflation is going to start to come back and be an issue for the Fed to take action."

But others such as FBR's East disagree. He expects the Fed will look to ease rates in the second half of next year.

East's view rests on his assumption that GDP growth will be below trend in the first half of 2007. This means that by the Federal Open Market Committee's June meeting, there will be a year's worth of data showing a weak economy.