The 'R' Word? Try 'Resilient'

If a recession were imminent, there would be clearer signs by now. Instead, consumers are still spending, and companies are expanding production

Investors can't seem to decide whether their biggest worry is recession or inflation. Or maybe both. Several economic reports for November came in surprisingly upbeat, especially some from the closely watched consumer sector, but they failed to allay Wall Street's recession concerns. Then came some nasty looking November price indexes, and inflation fears took over. In the unsettled economic and financial climate of the past few months, investors can be excused for being so jumpy. However, the resilience in some of the recent data makes an important point: If the economy were going to fall off a cliff, most likely there would be some signs of it by now.

On the contrary, job markets have slowed, though not abruptly. Manufacturing has weakened, but the strong 0.5% gain in November production suggests it is far from swooning, and the solid 0.9% rise in output of business equipment implies that companies are still expanding production capacity. Business inventories have not spiked higher, as they would have if demand had suddenly fallen off. Perhaps most important, consumers show every sign of being still willing and able to spend. So many economists are nudging their projections for fourth-quarter economic growth up a notch.

One reason is the downright strength of November retail sales. The Commerce Dept.'s roundup of sales, which is far broader than the popular chain-store results, showed receipts rising 1.2% from October, and, after more complete data, it said its tallies of September and October buying were stronger than first estimated (chart). Even if December sales are weak, inflation-adjusted consumer spending in the fourth quarter appears headed for a growth rate of 2% or more, perhaps not too far off the 2.9% pace over the past year.

The November numbers don't mean consumers—or the economy—are out of the woods, especially as the housing slump continues to worsen. Shoppers most likely took advantage of retailers' heavy pre-Christmas price discounts. Nevertheless, the data are a sign that households successfully fought through the headwinds from tighter credit and soaring gasoline prices. And that eases recession worries.

Therein lies the dilemma for both investors and, especially, the Federal Reserve: If the economy is not as weak as feared, could it be strong enough to lift inflation? The bigger-than-expected increases in the November price indexes looked troubling. Even excluding energy and food, the yearly inflation rate for wholesale consumer goods has risen about a percentage point from this time last year. Prices of goods at the retail level had shown outright deflation, falling for the past year. But in November the declines stopped.

Recent price patterns outside of energy and food may well reflect the economy's momentum earlier this year. Growth surged during the middle two quarters of 2007, to an average of 4.4% at an annual rate. That was the strongest two-quarter clip in four years, and it may have helped some businesses to pass along rising costs for energy and labor by hiking the prices of final products. Also, because of the falling dollar, yearly inflation for imports, excluding fuels, has picked up to 3%, double the pace of two years ago.

However, while an outright recession may not be in the cards, the economy is clearly slowing, and pricing pressures are likely to ease as softer demand makes it tougher to raise prices. Recent signs that profit margins are getting squeezed suggest prices are not keeping up with costs. Slower job growth is already loosening up the labor market and holding down wage costs. Oil and gasoline prices are off their peaks, and they are apt to fall further as U.S. and global growth cool.

Investors may worry that stubborn inflation will limit the Fed's ability to cut interest rates. However, prices are most likely to heat up in 2008 if the economy turns out to be much stronger than expected. If so, it wouldn't need a lot of help from the Fed in the first place.

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