The economy continues to post solid growth, with GDP growth of about 3.7 percent for this year, but slowing to a still healthy 3.1 percent in 2005. Nevertheless, the outlook for next year could be less favorable depending on the course of oil prices. We think this positive trend in economic activity has allowed the Fed to raise the Funds rate from its historical lows without the risk of choking the economy. The so-called "soft patch" experienced during this summer appears to have been a one time hiccup. Industrial production has maintained its momentum of about 4.5 percent growth.

Despite the upturn in economic activity, a lot of attention has been paid to the meager jobs growth. In fact some analysts have called the current expansion a "jobless recovery," as if to imply that the President is really the "Chief Executive" fo the economy who only has to push the right buttons to get the economy rolling and jobs growing. This superficial linking of the growth in economic activity – as measured by GDP, with growth of employment is what w refer to as "linear" thinking, or projecting the future as a simple linear extrapolation of past trends. As we have explained in previous StratAlerts, the U.S. economy has undergone fundamental structural changes caused by the development of new technologies and the globalization of production with a profound impact on the production relationship between labor and output over which the current or any administration would have little control. Rather the challenge for the government is how to be more proactive in passing new laws that will give greater incentives for businesses to succeed in the ever present global economy, particularly small businesses, recognizing that these changes if effective would still take some time to materialize.

Inflation has held steady at 2.3 percent, based on our measure which uses a moving average of the CPI. We think the rate will edge up to 2.7 percent by the end of this year. Consumer inflation expectations according to the University of Michigan survey are currently at 2.8 percent. While we have fundamental differences with the Fed regarding the definition of inflation, we are in agreement with their strategy of raising the Funds rate as a defensive measure to rein in inflationary pressures. The recent surge in energy and other commodity prices have already hit suppliers in the first stage of production. So far, final goods manufacturers are resisting price increases from their suppliers, but we think they will eventually have to pass on some of the increase in costs to consumer prices.

Oil prices still pose the principal risk to the outlook. Higher oil prices affect the economy in two ways: first, it will be reflected in higher consumer prices as producers pass on the higher energy costs through the production chain; and second, it will reduce the purchasing power of consumers, thus weakening spending. If oil prices remain in the $30 to $40 range during the next year, we are likely to experience higher inflation with lower economic growth. The Fed’s policies will have an impact on this trade-off – between inflation and lower growth, through their decision to raise the Funds rate which is aimed at cooling off demand and thus dampening inflationary pressures. The experience of the mid-1970s when higher oil prices resulted in significantly higher inflation was a painful lesson for policymakers.

Interestingly, the long end of the yield curve has flattened somewhat during the past three months, contrary to what we were expecting. We still think the long end will begin to move up again as inflationary pressures become more noticeable. On the other hand, it appears that the government deficits as projected by the Congressional Budget Office are now expected to subside as a percent of GDP during the 2005-2010 period, which should contribute to a lower risk premium on the long end of the yield spectrum. However, the trade accounts continue to hemorrhage and we predict the deficit will reach a record 5.5 percent of GDP this year, thus heightening the risk of a dollar crash and a consequent increase in interest rates. We think the Euro could reach $1.35 during the first quarter of next year.