At midyear, it is appropriate to reassess the state of the U.S. economy and where it might be headed.

The good news is that the risk of inflation has declined from more than 40 percent at the beginning of the year to about 25 percent at this time. The bad news is that the risk of recession has not yet become negligible despite enormous strides in reducing excess inventories.

When the year began, we were overloaded with inventories. The Federal Reserve rightfully was worried about how consumers would react to falling production, rising unemployment, and the reduction in wealth that overproduction was bringing.

Although their subsequent pumping of liquidity into the system has not created much improvement in wealth and jobs continue to fall, consumers continue to spend. Indeed, their optimism has improved in the past two confidence reports.

Nevertheless, the consumer is dipping into savings (adding to margins, buying houses with more debt, using their equity lines, buying goods on credit, etc.) If the stock market does not sustain a rally soon, the consumer may find an inability to spend even if the willingness is there. That remains a problem.

Fortunately, the inventory overhang is beginning to improve. Manufacturing shipments have declined 3.4 percent in the first five months of this year compared to the comparable period last year. Inventories remain up, but only by 1.2 percent. A few months ago, shipments were down 6 percent and inventories were up 4 percent.

More work is needed to get inventories in line, but the drastic production cutbacks probably are over. That is why manufacturing measures, while still negative, show substantially less decay than earlier in the year. Sometime this summer, production should be able to improve, if other problems do not materialize.

Unfortunately, other problems are materializing. To solve the inventory problem, production has been slashed to slightly more than 77 percent of capacity. Traditionally, orders are cancelled when capacity falls below 77 percent. All those order delays announced by tech companies in recent days may be caused by exactly this problem.

Manufacturing orders were up in May, but more than half the gains were in semiconductors and autos. Computer and communication equipment orders continued to fall.

Also, those May gains in construction expenditures were in housing and education facilities. Industrial and office construction plunged.

While the inventory correction is nearing an end, the capital spending plunge could be 6 to 12 months away from bottoming. Because of previous capital spending, capacity still is growing more than 3 percent while the economy is growing less than 1 percent.

So much idle capacity will prevent prices from rising. Unfortunately, even with the higher unemployment, wage pressures are rising slightly. Higher costs and lower prices mean sharply lower profits. Thus, the Federal Reserve liquidity is merely offsetting the profit weakness in the financial markets. This causes volatile and directionless stock prices.

Finally, the world situation is deteriorating. While I was in Shanghai last month I read the port activity for May from that vibrant Chinese port. A year ago, shipments from the port grew 40 percent. This May, the growth was only 3 percent. This is more evidence that the world economy continues to slow.

Could we be solving an inventory problem at home only to be confronted with a global recession? That is why the recession risk remains relatively high even as we are resolving our inventory problem.