FROM THE OFFICE OF PUBLIC AFFAIRS

When you were here three months ago, real growth had shaded down to a little above 3-1/2 percent annual rate in the first half of this year. The quarterly pattern of growth had been irregular: 5-1/2 percent annual rate in the first quarter and less than 2 percent in the second. But that reflected a swing in inventory investment. Domestic final demand was about equally strong in both the first and second quarters, more than offsetting the drag from an absolute decline in our exports to Asia and elsewhere.

Some key inflation measures actually edged lower in the first half of the year and others showed only modest upward drift. Strong growth and low inflation continued to coexist, despite low rates of unemployment and tightening labor markets. The Asian situation and the possibility of even broader financial contagion were recognized as a threat. But domestic considerations alone seemed to suggest a path of somewhat slower but healthy expansion in the second half of this year and beyond.

The domestic economic situation has evolved closely in line with expectation over the last three months. It is events in financial markets both here and abroad that have moved more rapidly and unpredictably than one could have anticipated. Inevitably, this introduces an element of uncertainty into the near term economic outlook that was not present to nearly the same degree when you were here three months ago. The basic difficulty is in knowing how much the process of financial deleveraging, which seems to be well underway, will exert an adverse and unwanted effect on real economic activity.

Some of the recent financial turmoil may have little lasting adverse impact, to the extent that it amounts to a zero-sum game with someone gaining what someone else has risked and lost. A heightened respect for risk may even have some beneficial consequences. But where leverage has been so excessive as to affect the functioning of markets, the situation must be taken very seriously. There is always the possibility that the pendulum may swing too far. After virtually disappearing, credit-quality spreads have widened sharply and credit availability has at least been temporarily interrupted in some markets. There is in such circumstances the potential risk that a market-induced process of credit restraint -- a private credit crunch, if you will -- could snowball and go farther than anyone desires. It is encouraging that some spreads have narrowed recently and that markets may be in the process of stabilizing.

One aspect of the current situation suggests that a favorable outcome is far more likely than might otherwise seem to be the case. Past episodes of credit excess and quality deterioration have typically occurred because of an inflationary environment and eventually only been brought to an end by monetary tightening. The current difficulties, whatever their ultimate origins, are occurring in a low-inflation environment within which the monetary authorities have already made offsetting moves toward ease. This may not completely forestall some adverse impact from the deleveraging process, but it would seem greatly to reduce the likelihood of any serious credit-dampening influence that might threaten the continuation of the current economic expansion.

As matters stand, the economy seems to be expanding at a rate fairly close to its longer- run potential, after a period of above-trend growth in the last two years. Unfortunately, we are viewing the recent past in the flow of current and immediately forthcoming official statistics. For example, the third-quarter was concluded a month ago. Yet we will not have the first look at third-quarter GDP until later this week. Obviously, those results will predate much of the recent financial turmoil and will tell us where the economy has been, rather than necessarily where it is going. But even that is worth knowing and may provide some guidance as to future developments.

The economy seems to have downshifted in the third quarter to a slower rate of expansion, from the first half's 3.7 percent annual rate, perhaps to something closer to 2 percent. Inventories had been a big swing item during the first half but will apparently exert a relatively neutral influence in the third quarter. More importantly, inventory-sales ratios remain at historically-low levels and there is little indication of the types of inventory imbalance that have sometimes given trouble in the past. Real personal consumption expenditure (two-thirds of GDP) seems to be on a sustainable track. The 6 percent annual rate increases in the first and second quarters were associated with a sharply falling personal saving rate and with some special factors (unusually mild winter weather in the first quarter and heavy discounting of autos and light trucks in the second quarter). If consumer spending were to have tapered down to a 3 percent annual rate of growth in the third quarter, as it may have, this would not signify any collapse in consumer spending but simply a return to a more sustainable path of expansion.

Rising anxiety about international turmoil is beginning to chip away a little at consumer confidence. Both the University of Michigan's index of consumer sentiment and the Conference Board's consumer confidence index have backed off from their peaks earlier in the year. But the declines are from very high levels and may not translate into as much consumer retrenchment as would a clear threat to the continued growth of domestic employment and income.

Up to now, the most obvious consequence of the global financial crisis has been reduced demand for U.S. exports, largely but not entirely due to Asia, and a noticeable weakening in U.S. manufacturing activity since the beginning of the year. Increases in our manufacturing production have dwindled despite strong investment and consumer spending in this country. Excluding motor vehicles, where production has been distorted by the GM strike, manufacturing output slowed from growth of 6 percent over the four quarters of 1997 to less than half that in the first half of 1998 and to a small negative in the third quarter. As production has slowed, there has been a growing weakness in manufacturing employment as well. Factory jobs have fallen by about 150,000 since January after rising by more than 250,000 in 1997. These developments and their implications for the capital spending outlook will need to be followed closely.

So there have been significant shocks to both the U.S. real economy and to its financial markets. But the economy remains robust and there continues to be good forward momentum. The most probable outcome going forward would appear to be growth somewhere near the economy's potential and the continuation of low rates of inflation.

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