FROM THE OFFICE OF PUBLIC AFFAIRS

When you were here three months ago, the economy had completed a quarter of a little over 4 percent real growth. That extended a record of 4 percent real growth which had persisted for some three years, with only occasional variation in quarter-to-quarter growth rates, frequently attributable to special factors. Now, according to last week's advance Gross Domestic Product estimate, growth in the second quarter fell a good deal short of 4 percent, to only a little more than 2 percent. A key question is whether the second-quarter result will turn out to have been just another one of those occasional quarterly variations, or whether it means that the economy is shifting down to a more sustainable pace.

The case for a smooth downshift rests primarily on the fairly general extent of the moderation in spending that emerged in the second quarter and the relative absence of any obvious imbalances.

• Real personal consumption expenditure (two-thirds of GDP) moved down to a 4 percent growth rate in the second quarter with roughly comparable degrees of deceleration in spending on durable and nondurable goods. By June, spending on consumer durables had flattened out.
• Growth in real fixed investment spending shaded down slightly in the second quarter with gains in producers durable equipment, especially computers and other high technology components, offsetting relative weakness in investment in structures, both residential and nonresidential.

• Federal sector outlays declined moderately in both defense and nondefense categories, while state and local outlays, as recorded in the national income accounts, were virtually flat in the second quarter.

Inventories are the main reason for questioning whether something like the lower second-quarter rate of growth is likely to persist. Inventory investment, while remaining positive, fell below the first-quarter rate and subtracted nearly a full percentage point from second-quarter real growth, with much of the inventory drop in the second quarter due to an inventory valuation adjustment for rising oil prices. The ratio of inventories to final sales is currently at very low levels by historical standards. Some will argue that these low inventory-sales ratios have set the stage for a faster rate of growth in the near future as firms rebuild their stocks. That is a possible outcome, but inventories are usually depleted when demand is stronger than expected. If anything, the second-quarter surprise seems to have been the softer pace of sales growth as the quarter progressed. Under the circumstances, inventory rebuilding on any significant scale may depend on the appearance of more positive sales performance, although some precautionary inventory buildup may occur more or less independently later in the year because of the Y2K transition

There are signs in the recent statistical record that the third quarter is opening at about the same moderate pace at which the second quarter closed. It should be emphasized that there is nothing in the recent record that would suggest outright weakness.

• Trade surveys imply that sales at major retailers in July were running a little behind June but remaining close to plan. Press reports suggest that industry analysts anticipate a slight decline in the auto sales rate in July when it is reported later today, although this would be from a high level.
• Consumer confidence readings are still at elevated levels but appear to be coming down a little. The Conference Board's index of consumer confidence declined in July for the first time in eight months. The University of Michigan index of consumer sentiment in July, released on Friday, also declined somewhat, although job and employment prospects were still regarded very favorably by consumers.
• The National Association of Purchasing Management index, released yesterday, was lower than markets expected in July at 53.4 percent, compared to 57.0 percent in June. Most components pointed toward continued but slower growth.
• A leading indicator of capital spending -- orders for nondefense capital goods excluding the volatile civilian aircraft component -- dropped by 4 percent in June following a decline of nearly 3 percent in May (actual declines, not annual rates). This could mean that growth in investment purchases of equipment may be entering a phase of slower growth.

Admittedly, these and other statistics that might be cited are only straws in the wind. They do point rather consistently to moderation in the pace of activity recently, rather than any sign of acceleration back to higher rates of speed. That probably should be regarded as a favorable development. For one important sector that has gone unmentioned to this point is labor markets. And, they remain very tight.

That, of course, is a good thing from just about every point of view, except for inflation control. Once again, it has been shown that a rising tide does lift all boats. But there is the risk, latent to this point, but nonetheless real, that tight labor markets and strong final demands could begin to generate significant inflationary pressure. This may account at least in part for the fact that the other major statistic released last week -- the employment cost index -- had such a sizable impact at the time on financial markets.

The 1.1 percent jump in the employment cost index during the three months ending in June was the largest quarterly increase since the second quarter of 1991. It came on the heels, however, of a rise of only 0.4 percent during the first three months of the year -- the smallest in the history of the series, which dates back to 1982. Taken together, growth over the first six months of the year is a seemingly benign 2.9 percent annual rate, somewhat more subdued than the annual increases in both 1997 and 1998. On balance, therefore, last week's employment cost index results may have been more a reminder of inflation risk than a clear signal of trouble ahead.

Much will depend going forward on how rapidly the economy moves and how much or how little pressure this places on labor markets. Those markets are already tight but they do not yet seem to be radiating much inflationary pressure.

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