FROM THE OFFICE OF PUBLIC AFFAIRS

OF THE PUBLIC SECURITIES ASSOCIATION

BY DIRECTOR OF THE OFFICE OF FINANCIAL ANALYSIS

JOHN H. AUTEN

As is customary at these briefings, I will concentrate on what we take to be the fundamentals in the current economic situation. There have been a number of favorable developments in this six and one-half year economic expansion. None is more remarkable than the persistence of a low and stable rate of inflation. In terms of the chain-type price index for Gross Domestic Product -- one of our broader measures -- inflation started at 3 percent six and one-half years ago and is running closer to 2 percent now.

Inflation behaved quite differently during the only other long periods of expansion since World War II, 1961-69 and 1982-90. The 1960's started well with inflation around 1-1/2 percent but ended poorly with inflation closer to 5 percent and headed for a much higher peak by the end of the 1970's. The 1980's expansion started with relatively high inflation -- near 6 percent -- which was then reduced to 2-1/2 percent temporarily by mid-decade, only to have inflation build back up to 5 percent by the end of the period. And, the normal pattern in the shorter postwar cyclical expansions was always for inflation to rise. So something different -- and something better -- has been happening this time around.

Producer prices for finished goods have fallen this year at about a 1-1/2 percent seasonally adjusted annual rate. There was a false alarm in September when the index was up 0.5 percent but this was due to a one-time jump in cigarette prices reflecting the tobacco settlement and to a rise in car and light truck prices because of difficulties in seasonal adjustment with earlier-than-usual price discounting by the manufacturers.

The core producer price index, excluding the food and energy components, has increased at only a 0.3 percent annual rate this year. In addition there are few signs of any buildup of inflationary pressures at earlier stages of processing. Most intermediate and crude materials prices have either fallen or risen only modestly.

Consumer prices have risen at less than a 2 percent annual rate through the first nine months of this year, pulled down by declines in energy prices. The core consumer price index has risen at a 2.2 percent annual rate, the slowest rate of core price inflation in more than 30 years. And, prices of commodities (as opposed to services) at the consumer level have hardly risen at all -- at only about 1/2 percent annual rate this year.

The employment cost index released this morning edged up a little but seems to remain consistent with the pattern of low and stable inflation.

Over the twelve months ending in September, nominal compensation for civilian workers (wages and salaries plus benefits) grew 3.0 percent, a shade above market expectation and up from 2.8 percent in the twelve months ending in June. This is within the range of recent experience and does not clearly signal any significant change, particularly since productivity seems to have grown more rapidly in recent quarters.

Wages and salaries rose 3.5 percent in the latest twelve months, up from 3.2 percent in June. Benefits rose 1.9 percent, down a little from 2.0 percent in June. Benefits continue to grow more slowly than wages and salaries, holding down growth in total compensation.

Despite all this good news, the fact remains that the economy has pushed into a zone where inflationary pressures have frequently been experienced in the past. Furthermore, recent economic growth rates have been somewhat above expectation. For example, when we met three months ago the economy seemed to have grown at a little over 2 percent annual rate in the second quarter. Now farther along in the revision process that growth has been recalibrated to a little above 3 percent. The consensus expectation was that after a 4 percent rate of growth in the first half (nearly 5 percent in the first quarter and more than 3 percent in the second), the economy would move closer to its trend rate of growth in the quarter just completed. That does not seem to have been the case.

The advance estimate of third quarter GDP will not be available until this Friday, so all is guesswork at this stage. Most private estimates locate third quarter real growth somewhere in the low 3's, about where the second quarter ended up. Such a pace of growth, or even a somewhat higher one, would not be surprising nor would it necessarily be crucial in assessing the current situation or the near term outlook. Why is that?

A range of economic readings suggests that the pace of expansion was slowing as the third quarter progressed. For example, private payroll employment gains, adjusted for strike effects, averaged about 125,000 per month in August and September, compared to an average monthly gain of 225,000 in the first seven months of the year. Real personal consumption expenditures (two-thirds of GDP) were up sharply in July and then edged up much more slowly in August and September. Hence, strong third quarter growth will be partly statistical with earlier gains pushing up the quarterly average and obscuring the emergence of a slower pace as the quarter came to a close. As nearly as we can tell, the economy seems likely to maintain a moderate pace of growth in the foreseeable future while inflation remains relatively low and stable.

Another feature of third quarter developments deserves brief comment. The stock of nonfarm inventories in real terms grew at nearly a 6 percent annual rate in the first half of the year, about double the 3 percent rate of growth in final sales. Concern was expressed by some observers at the time that an inventory overhang might be developing which could seriously impede future growth prospects. Instead, it appears that the inventory buildup was well-timed to accommodate increases in third quarter consumer and business demand, serving as a safety valve rather than as a growth impediment. While the data are incomplete and conclusions necessarily provisional, an inventory adjustment which some had expected to grind on for a fairly long time may already have been largely completed.

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