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Q2 GDP May Show Contraction

Economic growth in the second quarter, already reported to have slowed to a snail's pace, faces the real possibility of being revised into negative territory in what could be the first step toward a formal recession.

The picture will become clearer this week after the much-anticipated releases of the June business-inventories report Wednesday and June trade data on Friday. A recession is classically defined as two consecutive quarters of shrinking inflation-adjusted gross domestic product, the total output of goods and services.

The Commerce Department's advance estimate last month put second-quarter growth at an annual rate of 0.7%. But many economists expect a more complete GDP report at the end of the month will show a contraction, though at present the consensus among most economists doesn't see a second negative quarter coming.

To produce its July 27 estimate, the Commerce Department's Bureau of Economic Analysis lacked some June data and had to make assumptions. "They're educated guesses, but they're guesses nonetheless," said Alan Blinder, a Princeton University economics professor and former Federal Reserve vice chairman.

Those assumptions are now being replaced with actual numbers, and they are pointing to a sharp downward revision.

The revised report will be released on Aug. 29, but two of the missing components will be out this week: business inventories and the trade deficit. Other reports already suggest inventories will be revised down. Deutsche Bank economists in New York suggested inventories fell enough in the second quarter to knock 0.5 percentage point off economic growth.

A wider-than-expected trade deficit would also hurt growth. "The huge wild card in this thing is the trade balance," said Ethan Harris, a chief economist at Lehman Brothers in New York who now expects figures for second-quarter output to be revised to show shrinkage of 0.3%. "We don't have a strong read on it."

Another factor likely to contribute to a downward revision to GDP is construction spending, where a technical error meant sharp downward revision in public-sector construction all the way back to the beginning of the year. Now economists at Morgan Stanley Dean Witter predict a downward revision of second-quarter GDP growth to "close to zero," and a 0.6% rate of contraction in the third quarter.

A revision large enough to knock second-quarter growth below zero wouldn't be unusual. For example, first-quarter GDP growth was initially reported at 2%, but then pushed down to 1.3% by the final report.

Amid these changing circumstances, the assumptions may not fully reflect the shifts in economic climate. "At these cyclical turning points, the errors in these estimates tend to be very large," said Anirvan Banerji, director of research at the Economic Cycle Research Institute in New York, which has said a recession is unavoidable.

While the U.S. economy is undeniably in the middle of a protracted slowdown, most economists expect the economy to grow in the third quarter, thus avoiding a recession, although lately they have been dropping estimates. They cite the lagged positive effects of interest-rate cuts, the tax rebate and a reduced impact of inventory reductions.

Mr. Banerji attributed this economic optimism to a "widespread misconception" that tight job markets imply there won't be a recession. "All six recessions from the late '40s to the early '70s, the unemployment rate was around [current] levels or lower when the recessions began," Mr. Banerji said.

Either way, the first quarter of contraction since the 1990-91 recession would be certain to grab headlines and influence policy makers. "There is a kind of magic-number quality to zero," said Mr. Blinder, the former Fed official. "There's enormous political significance in the number zero."

For the Fed's interest-rate-setting Federal Open Market Committee, the results of Wednesday's inventories report and Friday's trade-deficit number will be of keen interest. Chairman Alan Greenspan and his colleagues would probably be more aggressive about cutting interest rates if signs point to a contracting economy. The FOMC next meets on Tuesday.

In any event, the old definition of a recession, while useful, is still technical and academic. Even if second-quarter GDP growth remains barely positive after revisions, the quarter was still a dismal one. "If you have zero growth in the economy and the unemployment rate is steadily going up, that's going to feel like a recession to the regular Joe," said Lehman's Mr. Harris.