Top economists discuss the Federal Reserve Chairman Ben Bernanke’s announcement last week to keep interest rates at near-zero levels. Will Bernanke change rates to avoid a bubble? Is the Fed abating responsibility for the economy? What if inflation is a near-term risk? Also, talking to your clients about giving during the holidays. Opinions from: Barclays Capital, Beacon Trust Company, BlackRock and more…plus our weekly report calendar.

A Gentle Fed, From Dean Maki, Head of U.S. Economic Research and Chief U.S. Economist at Barclays Capital

Despite our relatively strong U.S. growth forecast, we expect the Fed to keep the funds rate target unchanged until September 2010 and to raise rates only modestly next year. The main reasons are that the Fed aims to eventually lower the unemployment rate substantially and to push inflation higher, both of which will require strong growth. The Fed is unlikely to raise rates solely to avoid potential asset bubbles.

The Fed interprets its mandate as seeking full employment and price stability. In this week’s release of the October FOMC [Federal Open Market Committee] minutes, the Fed will provide its longer run forecasts of the unemployment rate and PCE [personal consumption expenditures] inflation; these are the figures the Fed sees as consistent with its dual mandate. Last quarter, the Fed projected a longer-run unemployment rate of 4.8% to 5.0%. The current reading of 10.2% means that the FOMC believes its policy should be set to bring about more than a five  percentage point drop in the unemployment rate over time. The Fed interprets its inflation mandate as a 1.7% to 2.0% rise in the PCE price index; that goal is notably above current readings on the headline and core PCE price indexes. While we do see headline inflation bouncing back into the Fed’s preferred range soon, in practice, the Fed focuses more on the core PCE, which we expect to remain below the Fed’s preferred range. Thus, the Fed’s current objectives require a longer period of strong GDP growth, because the unemployment rate and inflation are, in large part, lagging functions of growth. Thus, if GDP grows as fast as we expect in the coming quarters, the Fed will welcome it, and is unlikely to respond by quickly raising rates.

Some argue that the Fed will want to raise rates relatively soon to prevent another asset bubble, but last week, Fed Vice Chairman Don Kohn, in our view a very influential member of the FOMC, argued that “under most circumstances monetary policy is not the appropriate tool to use to address asset-price developments or growing vulnerabilities in financial markets.” Instead, he argues that the Fed must remain focused on its goals of price stability and full employment. We do expect the Fed to gradually gain confidence as economic growth remains firm next year, and we look for modest tightening to start in September as the Fed grows more comfortable that the tail risks of depression and deflation have faded. Still, we think the Fed will be quite gentle, as it does not want to short circuit the multi-year growth boom it seeks.

The Punch Bowl Stays Till the Party Gets Out of Hand, From Fred Fraenkel, Chairman of Investment at Beacon Trust Company

The quote that most of you know is: "The job of the Federal Reserve is to take away the punch bowl just as the party gets going," referring to the need to raise interest rates when the economy is at its most active. Many pundits profess that the Fed is abrogating its responsibility by keeping rates at zero as the economy recovers. There is certainly a case that can be made that the stock market, gold, commodities and bonds have all done well because the return on cash is so low.

In fact, it’s no secret that not only the Fed, but all world central banks have not only supplied punch, but have spiked the punch bowl. When the world withdrew from fear, it was left to the public sector to supply punch or risk the world economy dying of thirst. In our opinion, inflation will arise from government bond issuance crowding out private borrowing and necessitating higher interest rates over the next few years. The issue is that we can think faster than things occur in the real world. The inflation probably isn't coming until 2011 or 2012. It's early enough to plan for, but not early enough to worry about it popping up in market action.

The thing we do have to worry about materializing in near term market action is the removal of the "punch bowl.” Chairman Bernanke is protecting the economy from a double dip and probably will until he's sure that we are past the danger of an aborted recovery. While the punch bowl is present, the U.S. banks have a freebie carry trade to rebuild capital and most investors are looking for a place to invest their zero return cash. Stocks, gold, commodities and bonds will continue to be the recipient of these flows.