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A Recession on Cats' Paws

The nation's manufacturing sector managed to slip into a recession with almost nobody seeming to notice. Well, until yesterday.

Wall Street was caught off guard when the Commerce Department reported yesterday morning that orders for durable goods, big items like home computers and factory machines, plunged almost 8 percent last month. That's a big number, but it really shouldn't have come as too much of a surprise. In two of the last three months, the manufacturing sector has shrunk, according to surveys by the Institute for Supply Management that have been out for weeks.

But the new report seemed to focus investors' attention on the problems in manufacturing and became one more reason for people to sell stocks. By the time the market opened in New York, stocks in almost every industrialized country had already fallen sharply. The trouble began in Asia, where the Chinese stock market plummeted, before spreading to Europe and finally this country. The Standard & Poor's 500-stock index ended up with a loss of 3.4 percent, its fifth straight daily decline and its worst since 2003.

All of which raises a question that would have sounded strange even a month ago. Is the entire United States economy in danger of going the way of the manufacturing sector? Is it possible that we're headed for a real recession?

For months now, the economy seemed to shrug off the forces weighing on it and just kept on growing. But those forces never went away. If anything, a number of them have gotten stronger. And that's the most worrisome part of the bad news from the nation's factories: it fits into a larger story.

As stocks were dropping yesterday morning, an economist named Ian Shepherdson wrote one of his regular e-mail messages to clients: “Manufacturing is in recession; Fed please take note." Mr. Shepherdson, it's important to mention, is not one of Wall Street's perma-bears. When manufacturing last shrank, back in 2003, he correctly insisted that it was a false harbinger.

But this time, the manufacturing downturn stems from a couple of larger economic problems. One, of course, is the housing slump, which has caused a big drop in new construction and much less demand for doors, windows, countertops and a lot of other things that kept factories busy in recent years.

In recent weeks, the troubles in housing have spilled into the financial sector. Big lenders like NovaStar Financial are paying the price for extending credit to people who couldn't actually afford the homes they bought during the real estate boom. With many of those homeowners falling behind on their mortgage payments, lenders are making it tougher to get loans. That's a sensible, and overdue, move. But it will hurt economic growth in the months ahead.

The second big problem for manufacturers is the series of interest rate increases that the Federal Reserve has imposed since 2004. They may seem like old news, because the last of them came eight months ago, but it typically takes a year to a year and a half for a rate increase to have its full impact. A lot of the big decisions affected by interest rates, like whether to buy a new car or a new piece of factory equipment, aren't everyday decisions. Only now are some families and businesses starting to react to the higher rates.

The economic news certainly isn't all bad. The housing problems still haven't turned into a crisis, thanks in part to interest rates that are still not high by historical standards. So the most likely situation is not a full-blown recession (often defined as two consecutive quarters of a shrinking economy).

The forecasters at the Economic Cycle Research Institute in New York, who have accurately predicted each of the last three recessions, argue that the current slowdown won't amount to much more than a lull. By the middle of the year, they say, low interest rates and healthy corporate spending will have the economy growing nicely once again.

Lakshman Achuthan, the institute's managing director, told me yesterday that he thought the odds of a recession over the next year were less than 20 percent. Mr. Shepherdson, the chief United States economist at High Frequency Economics, who's more bearish than most forecasters right now, still puts the odds at only 30 percent.

But for all the attention that formal recessions get on Wall Street, they are not really the benchmark that matters to most people. A significant slowdown that falls short of a recession can do a lot of damage to stock prices, profits and wages. Only in the last few months, for example, has the current expansion grown strong enough to give most American workers pay increases that outpace inflation. Those raises would be endangered if the economy were to slow from last year's growth rate of 3.4 percent to even 2 percent.

"This is going to get worse before it gets better," Mr. Shepherdson argues. "We're in danger of slipping into something very like a recession, if not necessarily hitting the technical definition. It would be big enough to hurt, that's for sure."

The main message of yesterday's worldwide stock sell-off, as well as the stealth manufacturing downturn, is that the economy is facing bigger risks than we imagined just a few weeks ago. In mid-February, Ben Bernanke, the Federal Reserve chairman, told members of Congress that he was worried about inflation taking off. The clear implication was that the Fed's next move might be to raise rates yet again to keep the economy from overheating.

Until yesterday, that seemed plausible. It doesn't this morning. Like stocks, the price of a futures contract tied to Fed policy shifted sharply yesterday. Before the day began, investors expected the Fed to hold its benchmark rate steady through the end of the summer. Now they are betting that the rate will be cut once before July and again by the end of the year. If that's all that is necessary to keep the economy healthy, it will be a relief.