Upon revision GDP growth in the July-September quarter was probably around 8% versus 7.2% as initially reported. Demand far outpaced production in the quarter as consumers spent their tax windfalls and as business took advantage of tax breaks to boost equipment spending. But mortgage refinancing activity collapsed during the quarter as interest rates backed up, wage and salary increases were virtually nil, the measured saving rate stayed low, and prices of necessities such as food and energy rose faster that income.

The positive cash flow effect from mortgage refinancing and tax breaks has now been exhausted. So for consumers to continue to spend freely wage and salary growth will have to accelerate and or employment growth will have to pick up sharply. In our view both of these are doubtful as it is hard to imagine business abandoning the strict cost controls that were instituted in recent years.

Further, it is hard to imagine much more employment growth in the retail and building trades sectors, and we are skeptical that business is about to embark on the kind of inventory building spree that is needed to boost production and payrolls. To be sure, some inventory accumulation is bound to occur, but for it to gain traction, demand growth has to be sustained.

In this regard we have frequently heard parallels being drawn to the 1993 period when employment began to expand, precipitating a period of sustained strength. But there is a major difference between the two periods which is being overlooked. Then, the consumer was in much sounder financial shape. Debt ratios were significantly lower, and the measured saving rate was about double its current level. We were hoping for a sustained period of low long term interest rates to restore the consumer to a sounder posture, but the bond market did not comply and the Federal Reserve did nothing to stop this past summer’s bond slide.

Now the economy needs strong gains in employment to sustain demand. And by strong we mean more than the 125K to 150K increases of the past few months, and which only serve to stabilize the labor market. For this the demand side needs to remain very strong, but how can the consumer, the government, and the residential construction sectors get any stronger when there is no pent up demand, when the homeownership rate is a record, and when the federal budget deficit is very large? We do not see it, and while we will admit that capital spending can continue to be propped by tax incentives, the other demand sector namely exports is unlikely to get much help from a weaker dollar as long as growth in the rest of the world is sub-par.

This is not meant to be alarmist. We have not and do not expect a relapse into recession. We are focused on the difference between above and below trend growth, with the trend rate being about 3.5%.

To be sure, above trend growth is likely this quarter, but with a shift in the mix from demand to production strength. Were this to continue capacity utilization would rise and some moderate pricing power would gradually emerge. But what if growth slips back below trend after this quarter, which is in fact what is being signaled by the past few months’ collapse in money growth, and by the typical lag between increases in energy prices and economic activity.

Given the disequilibrium condition of the consumer sector, this is in fact most likely in our view. If so, the policy response will be crucial. It has got to be unconventional because additional tax cuts are unlikely in view of the outsized federal deficit, and Federal Reserve action to reduce the federal funds rate will have little effect being that the rate is already so low. Finally, efforts to keep pushing the dollar lower will be fruitless because growth elsewhere is not going to accelerate if U.S. growth is faltering.

As we see it the Federal Reserve would need to get long rates back down quickly and by a lot so as to revive refinancing activity and boost the flow of liquidity thru the economy. Moreover, once the Fed gets rates down, it needs to keep them down. Otherwise the healing process will again be short circuited; the deflationary threat could become real; and political pressures for trade restrictions could intensify. Financial markets have already become unnerved at minor forays on the trade front. If broad based measures were hinted, look out!

Given this risk we are still friendly toward precious metals. And while admitting that it is probably still a little early, we are once again becoming friendly to the bond market. Right now it seems that everyone hates long term bonds so we will be watching carefully for the kind of sentiment shift about the economy’s growth path that will set the stage for another move down in long term rates.