Stability of the flow of incompressible viscous fluid in a circular pipe is studied numerically. A perturbation consisting of finite‐amplitude two‐dimensional and infinitesimal three‐dimensional parts is imposed on the basic flow. The temporal evolution of the perturbation is analyzed by direct numerical calculation of the Navier–Stokes equations. The two‐dimensional disturbances are independent of the streamwise coordinate and initially take the form of streamwise rolls. It is shown that the nonlinear development of two‐dimensional perturbations results in substantial spanwise modulation of the streamwise velocity component manifesting itself as a formation of streaks and the occurrence of inflection points. The modulated mean flow is found to be highly unstable to the three‐dimensional perturbations which are localized spatially near these points. An instability mechanism that includes the modulation of the flow by growing two‐dimensional disturbances and the inflectional instability of the modulated flow to three‐dimensional perturbations is proposed. ©1996 American Institute of Physics.