FROM THE OFFICE OF PUBLIC AFFAIRS

At the time of the last meeting of the Committee, the economy was experiencing a clear slowdown. A dichotomy had emerged between the consumer sector, where spending was well-maintained, and the business sector, where investment was faltering. The configuration of activity three months later remains similar but significant additional softening has developed in the business sector. Even so, some signs suggesting a brighter outlook have also become apparent.

Most of the recent summary measures of economic activity have signaled weakness. Among these developments was the release last Friday of the regular annual recalculation of the national income and product accounts. These revisions, reflecting the incorporation of new source data and some improvements in methodology, somewhat recast the features of the so-called "new economy." Real GDP growth during 1998 was revised up a little but growth for 1999 and 2000, measured fourth quarter to fourth quarter, was marked down to 4.4 percent and 2.8 percent, respectively -- both 0.6 percentage point less than previously reported. Most of the reduction reflected a sharp downward revision to business investment. Despite the revisions, the economic record remains impressive. Real GDP growth during the five years from 1995 through 2000 was reduced only marginally from 4.3 percent to 4.1 percent- a still commendable performance for the late stages of an expansion.

But the downshift in activity since the middle of last year has been dramatic.Real GDP growth has slowed to just over 1 percent during the year ended in the second quarter, from more than 5 percent during the same year-earlier period. The advance estimate for the second quarter indicates real growth at an annual rate of only 0.7 percent, down from 1.3 percent in the first quarter and the weakest in more than eight years.

The composition of growth in the second quarter also deteriorated relative to the first. In the first quarter, a steep negative swing in inventory investment deducted 2.6 percentage points from the real GDP gain but final sales of domestic product (GDP excluding inventories - a measure of underlying demand) soared at a 4.0 percent annual rate.

In the second quarter, by contrast, inventories were relatively neutral but real final sales edged up at only a 0.7 percent pace. Private final demand slipped even further, with no growth at all in the second quarter.

While all elements of private final demand softened somewhat in the second quarter, the critical household sector held up reasonably well. Consumer spending (two-thirds of GDP) grew moderately, at just above a 2 percent annual rate. Residential investment remained quite strong, and has maintained a healthy 8 percent pace of growth so far this year. Foreign trade is estimated to have been a mildly negative factor in the second quarter but the most precipitous downshift was in capital spending. Business fixed investment plunged at a 13.6 percent annual rate, paring almost 2 percentage points from real GDP growth and leaving a high backlog of capital goods inventories. This contrasts with the previous five years, during which investment contributed an average of 1-1/4 percentage point to real GDP growth annually. Investment had not fallen so much in one quarter since 1982.

The withering of capital investment reflects a combination of developments. Excess capacity, resulting in some cases from overinvestment but in others from the current weakened demand, was one factor. In addition, a widespread profit squeeze caused not only investment plans to be slashed but also private payrolls to be cut by 350,000 workers during the second quarter.

The above summary, describing a somewhat more fragile economy than might be desired, reflects past developments. While the risk remains that additional layoffs could eventually impede what now appears to be moderate growth in the household sector, more forward-looking indicators provide some basis for optimism.

• Consumer confidence and the composite index of the National Association of Purchasing Management have risen slightly over the past few months and at a minimum appear to have stabilized. These were the measures of economic activity that last winter provided the earliest warning of a stark reduction in demand growth.
• Initial claims for state unemployment insurance benefits have plunged by 70,000 from their June highs. Some portion of the decline may be attributable to difficulties in seasonal adjustment around the July auto industry shutdown, but claims at least seem to have halted their climb.
• Although manufacturing and to a lesser degree wholesale trade still have a significant inventory overhang, the inventory adjustment at the retail level appears to be virtually complete.
• Finally, the index of leading indicators has now risen three months in a row through June - the strongest performance in a year and a half.

At a time when the economy already appears poised to regain its footing, several important factors are aligned to support it going forward.

• The $38 billion in tax rebate checks now being sent out, combined with tax rate reductions, could lift consumers' real after-tax income by close to 9 percent at an annual rate in the third quarter. Although considerable uncertainty surrounds the impact on consumer spending behavior of this injection of income, our estimates suggest that real GDP growth during the second half of the year could be raised by more than 1 percentage point at an annual rate.
• The 275 basis points of monetary stimulus administered in the first half of this year was heavily front-loaded, with more than half that reduction achieved by late March. Its impact should soon become apparent, boosting demand as well as easing interest cost pressures on corporations.
• Lower energy prices will also be a positive factor, both for households and business. While OPEC's efforts to sustain petroleum prices have dominated recent news, the 20 percent drop in the price of crude oil and the near 60 percent fall in natural gas prices since last winter represent huge reductions that are unlikely to be reversed significantly in the near term.
• In addition, the Employment Cost Index indicates that wage pressures are also easing. Private compensation costs have receded from annual growth of 4.6 percent a year ago to 4.0 percent during the latest four quarters - another factor favoring the rebuilding of corporate profit margins.

Overall, while we cannot dismiss uncertainties about the progression of recovery in the business sector, it seems plausible that the worst of the slowdown may be behind us. The July Blue Chip private consensus forecast estimates real growth of 3 percent in the fourth quarter. At this point, there is little reason to believe that forecast would be far off the mark.

That is the current summary of recent economic developments and the near-term economic outlook.