FROM THE OFFICE OF PUBLIC AFFAIRS

When you were here three months ago, there were signs that a slower pace of growth was emerging. But this was a slowing from what had been very rapid growth in aggregate demand throughout last year and into the early months of this year. The difficulty at the time was in knowing how much the economy might slow down and for how long. On the basis of the information available, the most likely outcome appeared to be that growth would continue at a reduced, but still fairly strong pace close to the economy's potential. Last week's advance report on third-quarter Gross Domestic Product seems to confirm that something like that has been taking place. Third-quarter real growth fell to a little below 3 percent from a little above 5 percent in the first half of the year.

Indeed, if attention were to be confined exclusively to such broad measures of economic activity, the term "soft landing" would seem to be altogether appropriate. But there have been changes since you were here three months ago, which introduce elements of uncertainty into the situation as we now find it. There have been rising crude oil prices, growing tensions in the Middle East, and a terrorist attack on a U. S. navy vessel. The stock market has been volatile with weakness spreading from the "new economy" sectors to the general market and broad indexes recently testing this year's lows. In the fixed income area, Treasury yields have been drifting down with credit-quality spreads widening against private securities, and widening very sharply in the case of speculative-grade corporate issues. In addition, commercial banks are being encouraged by the regulatory authorities to evaluate the credit quality of their portfolios with extra caution in view of the possible effects of a long business expansion on risk assessments.

It is difficult to judge the possible significance of these and related developments. While still modest in size and scope compared to some recent financial adjustments, there is always the potential for unwelcome surprises. But, as matters stand, there does not yet seem to be any clearly-defined threat from the financial side of the equation to the continued advance of the economy. Certainly, that would appear to be the consensus view. For example, the October Blue Chip forecast by some 50 economists at major businesses, financial institutions, and research organizations, which was released earlier this month, called for a slowing in real growth to 3 percent in the third quarter -- close to what actually occurred. On average, real growth was projected by the group to rise to about 3-1/2 percent in the current quarter and then to remain close to 3-1/2 percent over the four quarters of next year. None of the panel members predicted recession.

Last week's decline in the headline real growth number from 5.6 percent annual rate in the second quarter to 2.7 percent in the third quarter may suggest a more abrupt slowdown in growth than has actually taken place. A slower pace of growth in the economy was clearly apparent by the second quarter and did not emerge suddenly in the third. Indeed, real personal consumption expenditure (two-thirds of GDP) picked up to a 4-1/2 percent annual rate of increase in the third quarter from about 3 percent in the second. Second quarter growth in real GDP had been boosted by two special factors. First, there was a sharply higher rate of inventory accumulation, some of which now appears to have been involuntary. Second, there was a second-quarter spike in federal purchases associated with Census hiring and a shifting seasonal pattern of defense purchases. Rough allowance for those two factors would reduce second-quarter real growth closer to a notional 3 percent, not greatly different from the third-quarter pace. If anything, the quality of growth may have improved in the third quarter with a firmer tone for consumer spending, the apparent end of the second-quarter's rapid inventory buildup, and a much slower rate of deterioration in net exports.

Another favorable feature of third-quarter developments was the continuation of good inflation performance. The Gross Domestic Product chain weighted price index increased at a 2.0 percent annual rate in the third quarter, down from 2.4 percent in the second quarter. The gross domestic purchases price index, which excludes exports and includes imports, rose from 2.1 percent to 2.4 percent.

The employment cost index results for the three months ending in September, also released last week, were generally favorable. Compensation costs increased a shade less rapidly than in the prior three-month period, with growth in both wages and salaries and benefit costs, tapering off a little. Despite the benign performance in the latest quarter, rapid growth in compensation costs earlier in the year has led to a much larger increase in the employment cost index over the past 12 months than over the prior twelve-month period. The saving grace has been rapid increases in productivity which has held labor costs per unit of output to rates of increase consistent with good price performance. Productivity estimates available later this week seem likely to confirm that this state of affairs continued in the third quarter.

The third quarter is history by now and we must depend upon scattered statistical readings and anecdotal reports for a sense of where the economy is heading.

• Existing home sales fell back a little in September but remained surprisingly high at over 5 million units at a seasonally adjusted rate. Mortgage applications are still high, inventories of unsold homes are low and home prices are rising. Residential investment was a negative factor in third-quarter GDP but may be stabilizing.
• Durable goods orders rose a little more than expected in September, but the key series on nondefense capital goods excluding aircraft - followed closely by economists as a leading indicator of business capital spending - edged down for a third successive month. The National Association of Business Economists has recently reported that an intense profits squeeze was developing for goods producers in the third quarter and that some firms are cutting back on capital spending.
• The recent behavior of initial claims for unemployment insurance does not point to much change in the current situation. Labor markets remain tight but the claims data also reflect the slower economic pace since the spring of the year. The four-week moving average of initial claims now stands at 307 thousand, some 45,000 above lows near 262 thousand registered in April.
• Recent press and anecdotal reports suggest some erosion of consumer confidence recently, although from very high levels. Early reports on retail sales in October speak of modest gains, in some cases somewhat below plan.

The economy seems to have moved fairly smoothly to a more sustainable pace of growth. Strong gains in productivity continue to dampen inflationary pressures. There are some financial and other uncertainties but further economic expansion at a solid pace seems to be the most likely outcome.

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