In our last Commentary we emphasized that in going forward the demand side of the economy should receive more attention than the production side of the economy. It is evident that the production side is strong as business is undertaking modest inventory rebuilding in addition to meeting current demand. Indeed, the various ISM surveys for November built on October’s strength in both new orders and backlogs. Production will remain strong near term, but for this strength to be sustained, demand conditions need to remain solid. Here we remain cautious.

As we see it, there are four principle headwinds that will restrain demand. First, all the household debt ratios are near historic highs while the measured saving rate is depressed. Second, the consumer is no longer benefiting from the positive cash flow derived from mortgage refinancing. And with mortgage rates up, housing is less affordable than earlier this year while the homeownership rate is a record. Third, it seems that much of last summer’s tax cut and rebate has already been spent. Although withholding rates are down, prices for necessities such as food and energy are up. Finally, there is a continuing absence of robust payroll growth.

Business decisions seem dichotomous. Inventories are undergoing a modest reaccumulation because they got inordinately low. Perhaps because of generous tax breaks which expire in 2005, capital goods orders are rising even though capacity is excessive. Nevertheless, payroll growth remains sloppy. Over the three months ended November only 293K jobs were added with wage and salary growth barely budging. Perhaps employers’ reluctance to expand payrolls is reflecting their own caution about the future strength of demand as well as a reluctance to shoulder the high overhead cost like health care and payroll taxes that go hand in hand with headcount increases.

Reflecting these headwinds, retail sales were lackluster in October-November and new and existing home sales retreated from lofty levels. This may well be the start of an extended period of slowing growth in these sectors. If so, overall economic growth will slow because neither capital spending nor export growth will be sufficiently robust to compensate.

With inventories being replenished, economic growth of 4% to 5% this quarter seems likely. But once shelves are restocked and next year’s tax refunds are funneled through the system, we would expect a return to trend growth at best. But the problem is that if job growth is meager with the economy rising above trend, there is no reason to expect an acceleration in employment if growth slips back below trend. We are encouraged that the Bush Administration seems to have gotten the message that trade restrictions are an ineffective weapon to combat a lackluster job market. However, with this likely to be a hot campaign issue, we think there is still the risk that punitive measures may be enacted.

This aside, if we are right in our anticipation of slower growth, pricing power will remain muted and the Federal Reserve will remain sidelined. Interestingly, the bond market has performed well over the past two months despite a stronger than generally expected performance from the economic indicators. Perhaps bond investors are sensing a coming slowing in economic activity, although we still think it is too early for the market to latch on to this theme. Once it does, bond rates will fall. And the Federal Reserve may very well ratify this fall with direct purchases of securities. After all, if growth falls below trend, there is the risk that household imbalance could force such a retrenchment that deflationary pressures may assert themselves. As is clear from various Fed statements, this is a less desirable outcome than one with some inflation.