FROM THE OFFICE OF PUBLIC AFFAIRS

When we met three months ago, the economy had moved fairly smoothly to a lower and more sustainable pace of growth. There were some financial and other uncertainties at the time, but further economic expansion at a solid pace appeared to be the most likely outcome. With the wisdom of hindsight, that now seems to have been a rather optimistic assessment. There has, as you know, been a run of much softer economic readings and a policy response earlier this month by the Federal Reserve to a changing set of circumstances.

Somewhat paradoxically, this economic downshift is still not clearly revealed in the economy's recent rates of growth. The advance estimate of fourth quarter Gross Domestic Product will not be known until tomorrow, but private estimates of real growth have been centered in the 1-1/2 to 2 percent range. This would be within hailing distance of the third quarter's 2.2 percent and would at least superficially seem difficult to reconcile with the increased pessimism and perception of downside risk that has developed. The discrepancy largely reflects nothing more profound than the fact that Gross Domestic Product is measured on the basis of quarterly averages.

We do not have monthly data for Gross Domestic Product, but real personal consumption expenditure (two-thirds of GDP) is available monthly and can serve as a rough GDP proxy for illustrative purposes. Consumer spending started the fourth quarter well above its third-quarter average, about 2 percentage points above at an annual rate, made dwindling gains in October and November, and then weakened in December, when unit auto sales fell sharply. It is as if there were two fourth quarters: one as recorded in the GDP account quarterly averages, not very different from the third-quarter results; another as the picture has emerged in the evolving flow of real-time statistics, very different indeed.

However far back the origins of the current slowdown might be traced, two statistical releases - one late last year, the other early this year - were the alarm signals that both consumption and production might be weakening significantly.

• In late December, as the press reported at the time, the University of Michigan index of consumer sentiment tumbled by more than 9 percentage points to a two-year low. Consumers felt that the economy had weakened and expected it to deteriorate further in the new year.
• This was followed on January 2 by a much larger-than-expected decline in the index of the National Association of Purchasing Management which tracks activity in the manufacturing sector. Their December index was the lowest since April 1991 and close to the level which historically has corresponded with no growth in the overall economy.

These were the earliest available readings on the economy as it closed out last year and soon were followed by a number of other statistics, confirming that the pace of activity had, indeed, slowed in December.

• Sales at major retail chain stores edged up a disappointing 1/4 percent in December 2000 from a year earlier. This followed four strong years in which December sales rose by an average of more than 5 percent. The broader, official series on retail sales inched up by 0.1 percent in December in nominal terms, and earlier results for October and November were revised down.
• Private sector employment gains slowed in December, although the unemployment rate held steady at a low 4.0 percent. But the shocker was a 62,000 drop in manufacturing employment and a plunge in factory work hours, possibly aggravated by severe winter weather in the Midwest. This was reflected in December industrial production which fell by 0.6 percent, pulling the fourth quarter down at a 1.1 percent annual rate, the first such quarterly decline since 1991.
• Finally, the Conference Board's composite index of leading indicators fell by 0.6 percent in December. It has been pointing toward a slowing trend since last spring and now is coming closer to an outright warning of a downturn but is not there yet. One problem of interpretation is that much of the weakness in the leading indicator index is due to its yield curve component which has shown a sustained inversion over the past year. That may reflect special factors that were not present in the past, such as the Treasury buyback program, since substitution of a AAA corporate index for the 10-year Treasury seems to remove the inversion.

There is a different, somewhat more positive, tone to scattered reports on activity in January. It is difficult to be sure how much importance to attach to these latest fragmentary readings, but they tend to undercut the notion that the economy is in anything like a free fall. Trade sources suggest that consumers may have picked up their pace of spending with sales above plan for some retailers. Mortgage refinancing took a big jump in early January as mortgage rates fell below 7 percent. More generally, the housing sector has remained at a relatively high level of activity. That may be changing with recent declines in building permits and existing home sales, but the surprise is how resistant housing has been. Initial claims for unemployment insurance, which soared to the highest level in 2-1/2 years at the end of December, have fallen back in January and suggest that labor markets are still tight.

Inflationary pressures have remained relatively subdued in recent months. While inflation remains a significant problem, the slowing pace of real activity is a more immediate concern.

• The consumer price index rose at a 2.1 percent seasonally adjusted annual rate in the three months ended in December and the core rate (excluding the food and energy components) rose at a 2.0 percent rate. Both of these rates were well below the corresponding rates over the 12 months ending in December: 3.4 percent for the total CPI and 2.6 percent for the core.
• The employment cost index, released last week, showed a surprisingly modest increase for the three months ended in December - well below market estimates. Hourly compensation (wages and salaries plus benefits) rose by a seasonally adjusted 0.8 percent or 3.3 percent at an annual rate. This was well below the 4.1 percent advance over the 12 months ended in December.

Looking to the future - a hazardous enterprise at best - it seems likely that the current quarter will be relatively weak statistically. From a narrow technical point of view, first quarter real growth will suffer from a low starting point - the reverse of the fourth quarter situation. In addition, first quarter growth may be held down by seasonal adjustment factors which will reflect a run of mild winters in the recent past and present a fairly high statistical hurdle to clear. From a more fundamental point of view, at least a moderate inventory adjustment is underway. But these have occurred before during the current expansion without lasting adverse impact. It hardly needs repeating that downside risk for the economy has increased; but there are also important elements of continuing strength, too easily ignored when pessimism temporarily becomes the dominant theme.

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