The “advance” estimate of third quarter Gross Domestic Product growth, released by the Bureau of Economic Analysis Friday, at 3.8 percent, was greeted by the stock market with a huge sigh of relief. It appeared to vindicate the view of market bulls and the George W. Bush administration that the U.S. economy remained in fine shape. On closer analysis, however, and taking into account other recent economic announcements, the picture is much gloomier.

For a start, this is only the “advance” estimate of third quarter GDP. It includes estimates rather than hard data for September. Since we know that durable goods orders in September declined by 2.1 percent, a much larger drop than economists (or, presumably, the BEA) had been expecting, the revisions in the “preliminary” and “final” GDP figures, to be announced in late November and late December, are likely to be substantial, and concentrated on the downside. (There is also a further revision to GDP figures in the following year, almost always downwards, stripping out the over-optimistic estimates with which Wall Street has been beguiled – needless to say these further often substantial revisions are almost entirely ignored by Wall Street and the media.)

According to the BEA, the average revision to quarterly real GDP figures between the advance estimate and the final post-revision result in 1978-2002 was 1.5 percent, so there’s plenty of room for variation.

Second, the GDP estimate, even without final data for the inflationary September, showed the price index for domestic purchases rising 4.0 percent in the third quarter, continuing a steadily increasing trend in inflation from a low of 1.6 percent in 2001. This figure is itself low; it includes a BEA estimate of the “hedonic” benefit from faster chips in the tech sector, which has been estimated to subtract about 0.8 percent per annum from the “raw” price increase data that was used until 1995.

Third, the components of the increase in real GDP are themselves disturbing. Real government spending expanded at a rapid 7.7 percent, accounting for 0.61 percent of the 3.8 percent rise in real GDP. In addition, motor vehicles and parts accounted for a further 0.62 percent of the 3.8 percent, driven by the huge incentives available to automobile buyers during that quarter that led both General Motors and Ford to report large losses. Furniture, accounting for 0.35 percent of the 3.8 percent gain and residential construction investment at 0.28 percent are further areas that can be expected to decline. Netting out these largely unrepeatable or economically damaging factors produces a sustainable growth in private sector GDP of a mere 1.9 percent, even before future downward revisions.

More interesting than data for a quarter already four weeks over is the question of where we go from here. The University of Michigan Index of Consumer Sentiment for October was reported Friday at 74.2, down 2.7 from the previous month and 22.3 from its July level of 96.5. This is a considerably lower level than the September 2001 nadir, after the September 11 attacks, of 81.8. It is indeed the lowest level reached since the Index touched 73.3 in September 1992. The 3 month drop of 22.3 percent to October 2005 is close to the 24.3 points (to 63.2) in July-October 1990, which was the steepest short term drop in the Index’s 53 year history, greater than any equivalent drop in the deep 1979-82 or the 1973-75 recessions.

This, not the benign and misleading “headline” GDP number is a better indicator of where we go from here. September’s Michigan number may have been affected by Hurricanes Katrina and Rita, but there was no equivalently damaging storm distorting October’s consumer sentiment, while fuel prices, also a problem in September, had dropped back by the time October’s consumers were polled. When consumer sentiment drops so sharply, you have a leading indicator of economic hard times ahead (and the Conference Board’s Index of Leading Indicators, reported October 20 at down 0.7, is also predicting trouble, as it has been for a year now.)

We now come to the nomination of Ben Bernanke as Chairman of the Federal Reserve Bank system, a nomination that has been welcomed by the market and is almost certain to be confirmed by the Senate. As I wrote here last week, Bernanke is an inflationist. Nominally, he favors “inflation targeting” by which the Fed sets an inflation target of say 1-2 percent and then attempts to maintain interest rates at a level that keeps inflation within the target range.

There are two problems with this approach. First Bernanke intends to define inflation on a “core” basis, leaving out food, energy, house prices and asset prices in general, but still taking account of “hedonic” improvements in the tech sector. By this Enronesque means, a period of spiraling asset and commodity prices can be massaged away to produce inflation statistics that justify easy money, thus maintaining Bernanke’s popularity on Wall Street and in the White House.

Second, since the portion of inflation targeted by Bernanke is that least sensitive to monetary conditions, it is a heavily lagging indicator of monetary conditions. Thus when “core” inflation moves above the target range, money supply growth has already been excessive for 18-24 months, and a corresponding period is needed to bring inflation back within the desired range.

To see how this works, one can “back test” Bernanke’s inflation targeting against the inflation spike of 1971-74, which brought the great postwar boom to an end, set the United States on a markedly lower productivity growth track and began the reversal of the sustained improvement in living standards that had been enjoyed by the U.S. working class over the first three quarters of the 20th century.

By Bernanke’s definition, “core” inflation would have remained restrained throughout 1972 and 1973. In the 2 years following the August 1971 institution of price controls, “core” CPI inflation remained steady at 3.0 and 3.3 percent per annum, or only about 2.2 and 2.5 percent per annum once a “hedonic fudge factor” of 0.8 percent per annum is stripped out. True CPI inflation, without the fudge factor, was only 2.7 percent in the first year after August 1971, but rose to 5.4 percent in the following year (August 1972-August 1973). In the third year after August 1971 (1973-74) inflation was out of control by any measure, being 9.0 percent on a “core hedonically adjusted” basis and 10.8 percent on a true basis.

Thus true inflation would have signaled a warning to Bernanke a full year before “core hedonically adjusted” inflation.

A monetarist would have seen the problem a year earlier still; growth in M3 money supply from August 1971 to August 1972 was an outrageous 13.8 percent, an increase of 11.1 percent in real terms. M3 money growth decreased slightly to 13.3 percent in 1972-73 and fell to 9.3 percent (a contraction in real terms) in 1973-74.

In other words, in periods of inflationary stress Bernanke’s inflation targeting system doesn’t work at all, giving signals far too late. Conventional inflation targeting works a little better, while Paul Volcker-style monetarism works best of all, giving the earliest signals.

With sharply reduced consumer confidence and a weak Fed Chairman, the U.S. economy’s trajectory for 2006 is now pretty clear. GDP growth will decelerate sharply over the next couple of quarters, probably turning negative in the first or second quarter of 2006. Since Bernanke takes over January 31, he will be within days of doing so when sharply lower growth is reported for the fourth quarter of 2005, and well in place by the time negative GDP growth reports appear in April or July 2006. By that time, the stock market will have dropped substantially, the housing market will be cracking and consumer credit delinquencies will be soaring. The Bush administration and Wall Street will panic, and will pressure Bernanke to lower short term interest rates, a pressure to which he will almost certainly respond.

The second half of 2006 may thus show renewed economic growth and lower interest rates (and even a bounce in the stock market) but at the cost of rapidly accelerating inflation, manifest first by new highs in oil, gold and other commodity prices. Even if Bernanke’s monetary loosening is successful in producing a relatively attractive economic picture at the time of the 2006 midterm elections in November, by the end of the year or very early in 2007 the truth will be manifest for all to see: as in 1972-74, a loose monetary policy at the Fed will have produced inflation climbing into double digits, combined with economic growth once again turning negative.

A re-run of the 1973-74 recession, with accompanying stock market, bond market, consumer credit and housing market crises, is about the best we can hope for. This time around, the downturn could very well be deeper than in 1973-74, and will almost certainly be longer.

Buy gold, short the Long Bond!

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International.