Economy Climbing Off the Canvas

After contracting for more than a year and a half, U.S. manufacturing grew in February, offering further evidence that the downturn has ended and an economic recovery is under way.

The Institute for Supply Management said its purchasing managers' index rose to 54.7% in February from 49.9% the previous month. Analysts had expected a reading of just 50.9%.

"February signals the turnaround for manufacturing based on a strong PMI reading and an accelerating trend in new orders and production," said ISM chairman Norbert J. Ore. "Most of the indices are heading in the right direction at this point."

The forward-looking new orders index rose to 62.8% in February -- the highest reading since October 1994 -- while the production index surged to 61.2% from 52% in January.

Ore said that while employment is still soft, this tends to be a lagging indicator, "and will need a number of months of growth before it recovers." Pricing power is also lagging, but should improve if the trends in new orders and production continue, he noted.

"Ignore the ISM at your peril," said Ian Shepherdson, chief economist at High Frequency Economics. "[But] now that the recovery has announced its arrival in such grand style, how long can rates stay at 1.75%?"

Fed funds futures are now pricing in a 37% chance that the Fed will increase interest rates in May, up from 25% prior to the data's release. The June contract is pricing in a 100% chance of a hike, up from 80% before the data was released.

"All of the optimism from [Fed chief Alan] Greenspan's testimony has been reversed," said Tony Crescenzi, chief bond market strategist at Miller Tabak.

David Gitlitz, an economist at DG Capital Advisors, believes the strength in the ISM is deceiving because, he says, production was bound to ramp up amid such huge inventory liquidations. "If all we're getting is a normal rebound of inventory, it's not necessarily a signal that we're in sustained growth mode," he said.

Some economists also noted that consumer sentiment unexpectedly fell to 90.7 in February from 93.0 in January, as recent declines in the Nasdaq and persistent worries about corporate accounting took their toll. Still, evidence supporting the turnaround theory continues to build.

Construction spending jumped 1.5% in January compared with expectations for a 0.3% gain. In addition, U.S. personal spending increased more than expected in January, and personal income rose at its fastest pace in six months.

The Commerce Department said incomes grew 0.4%, much stronger than the 0.1% increase projected by analysts, as tax cuts, increases in Social Security benefits and a federal pay raise countered an overall drop in wages and salaries.

Consumer spending also rose 0.4%, and data on November and December spending were revised higher. Spending grew at a 6% annual pace in the fourth quarter, the fastest since mid-1998.

"In short, this is another recovery report," Shepherdson said.

Despite the increase in spending, the savings rate also rose to a four-month high of 1.8% from 0.6% in December.

"It was all very strong and has prompted us to guide upward our forecasts for the first and second quarter," said James Glassman, senior economist at J.P. Morgan Chase.

Glassman is looking for 3.5% growth in the first quarter and 5% growth in the second. On Thursday, fourth-quarter GDP was revised up to 1.4% from a previously reported 0.2% gain, indicating that the U.S. economy will avoid a recession as defined by two quarters of negative growth.

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