Fed Walks Economic Tightrope

The markets aren't sure whether to buy the idea that the U.S. economy is heading toward recession.

It's hard to blame traders when economists and the Federal Reserve are so divergent about the economic future. Wednesday may bring some enlightenment in the form of the Fed's beige book, its intermeeting report on the state of the economy.

On the strong side, analysts expect third-quarter growth to be revised to around 5% on Thursday. Job growth has remained sturdy despite a second leg down in the housing market and financial market turmoil that's gripped the second half of the year. And Fed speakers have been cautiously trying to bat back expectations for more fed funds rate cuts.

Fed in a Jam?

On the weak side, economists note that there is more than $200 billion worth of adjustable-rate mortgages set to reset at higher rates next year on the heels of the biggest drop in residential real estate in decades.

"We're in a high-risk situation, probably one major shock away from recession," says Ethan Harris, chief economist at Lehman Brothers.

It's hard to know what the shock might be, however, given some confusing market responses lately. Tuesday the stock market rebounded sharply, and bond prices fell after a panicky Monday that sent yields in the Treasury bond market to multiyear lows and the stock market into official "correction" territory. The shift came despite a report of plunging consumer confidence and a Goldman Sachs research note suggesting that the economy is in for a nasty slide.