The second quarter proved to a relatively disappointing one for economic growth, as the increase in real GDP slowed to a 3.0 percent annual rate. The weakness was concentrated late in the quarter: in June, consumer spending fell 0.9 percent in constant dollars, the largest decline since September 2001, and manufacturing output edged down 0.1 percent. This advance estimate of GDP is made without the benefit of data on inventories or trade for the final month of the quarter. It is possible that June inventory building was larger than anticipated. If so, second-quarter real GDP growth could be revised up. But the downward momentum of consumer spending and manufacturing output heading into the third quarter would suggest another quarter of moderate GDP growth.

Fragmentary data from the month of July provide a mixed reading on where the economy is heading this quarter. The July employment report was considerably weaker than expected, with the number of payroll jobs increasing by just 32,000, as businesses apparently put their hiring plans on hold in light of the second-quarter slowdown. Auto sales rebounded last month, however, and consumer confidence rose. The ISM indexes for both manufacturing and non-manufacturing were both up last month. Applications for loans to purchase homes have revived in response to lower long-term interest rates. The economy could be emerging from the "soft patch," although that certainly is not clear at the present time.

Slowdowns of GDP growth in the midst of an economic expansion are the rule, not the exception. For example, the latter half of the 1990s was clearly a period of robust economic activity: real GDP increased 4.1% at an annual rate from 1995 through 2000, well above the economy's potential long-term growth rate. But growth slowed to around 3% or a little less in Q1 1996, Q1 1997, Q4 1997 and Q2 1998.

There is reason to expect the current slowdown to be temporary, eventually to be followed by a pickup in activity; the expansion remains under girded by strong fundamentals. Productivity growth accelerated during the recession and early stages of the recovery, generating large increases in corporate profits. Job gains, lacking earlier in the expansion, began to kick in almost a year ago, bringing with them an improvement in consumer confidence. Business capital has revived; housing activity remains elevated; exports are recovering nicely; and inflation and interest rates are both at low levels.

One obvious fly in the ointment is the rise in energy prices, which is siphoning off consumer purchasing power. Where energy prices are headed is hard to say, but forward prices suggest, at least, that the worst is behind us. If so, the drag on real disposable income may soon abate. There is, of course, a threat of domestic terrorism facing American citizens and potentially the economy. How large a threat to the economy would depend on the nature of the terrorist attack and how businesses and consumers responded to it. The events of 9/11, which were an enormous human tragedy, were also a severe setback to the travel industry, but they hardly made a dent on the macroeconomy. Consumer spending, which dropped considerably that September, rebounded hugely in October, setting the stage for an emergence of the economy from recession to recovery in the fourth quarter of 2001. And by the first week of November, the stock market had recovered all of the post?9/11 losses. An outbreak of widespread and continuing terrorism could send consumers into hibernation, but if that can be avoided-and that is certainly probable with today's heightened security-the economy should continue to grow at an above-trend pace once it emerges from the soft patch.

An essential ingredient to continued solid expansion is avoidance of a significant worsening of inflation. The most immediate threat to inflation stems from the possibility that oil prices may continue to rise for a time before flattening out and eventually turning down. Prices of basic commodities other than food and energy, however, have turned down already, following a sharp run-up earlier.

Of critical importance to the longer-run trend of inflation is the course of unit labor costs, which comprise roughly two-thirds of a typical business' costs. In the past several years, unit labor costs have been declining, thanks to strong productivity gains and muted increases in compensation per worker. But with productivity gains likely to slow as the expansion proceeds, and wages rates apt to move up as labor markets tighten, unit labor costs will move into positive territory, acting as a floor under inflation, if not exacerbating it.

Avoiding higher inflation as the expansion continues will require the Federal Reserve to continue with its announced plans to increase interest rates gradually to more normal levels. At its August 10 meeting, the Fed raised the funds rate an additional 25 basis points to 1-1/2 percent, stating that "…the economy appears poised to resume a stronger pace of expansion going forward." If that expectation proves correct, short-term interest rates can be expected to move rather steadily upward throughout the remainder of this year. Our forecast for next year, a 3-3/4 percent growth rate, would suggest continued moves by the Fed to raise short-term interest rates. We expect the funds rate to be roughly 4% by the end of next year.

There will undoubtedly be negative effects stemming from higher interest rates in the credit-sensitive industries, especially housing. But the Fed evidently intends to avoid the abrupt rise in interest rates that occurred in 1994, which slowed the economy substantially early in 1995 and forced the Fed to reverse course for a while. The "measured pace" of removing monetary accommodation which the Fed has announced has the potential of permitting the economy to grow at a pace somewhat above the economy's long-term potential (which we would estimate at around 3-1/2%) at least through the end of next year, if not longer.

Our forecast for this month follows broadly the lines laid down a month ago. We believe that soft patch the economy traversed in the second quarter will be temporary. We expect the economy to grow at about a 3-1/4 percent rate in the third quarter, and the fourth quarter to be notably stronger than the third. We anticipate continued expansion at about a 3-3/4 percent rate next year. We expect the inflation rate to stay close to the Fed's comfort zone, which we believe is 1 to 2 percent, as measured by the core component of the chain-price index for personal consumption expenditures. But the risks in the inflation forecast are more likely to be on the upside than the downside unless economic growth falls considerably short of our expectations.

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