Rising Prices Put Pressure On Already Ailing Economy
Oil, Manufacturing Numbers Get Year Off to Bad Start

By Neil Irwin
Washington Post Staff Writer
Thursday, January 3, 2008

For anyone who is worried about the economy, 2008 is off to a lousy start.

The price of oil briefly rose to $100 a barrel for the first time yesterday and fresh evidence emerged that the economy is slowing. To investors, the news raised the specter of stagflation, the toxic mix of stagnant economic growth and price inflation that made for hard times in the 1970s.

The Dow Jones industrial average fell 1.7 percent, or about 221 points, as investors moved money into safer investments.

"Not very fun, is it?" said James W. Paulsen, chief investment strategist of Wells Capital Management. "The news today just conjures up some frightening possibilities. Happy New Year."

After months of flirting with a price of $100 per barrel, one midday trade for crude oil on the New York Mercantile Exchange yesterday was for that much. The price of a barrel closed at $99.62. Gold closed at an all-time high of $860 an ounce for the February contract. The prices of wheat, soybeans and frozen concentrated orange juice were all up sharply, too. The dollar fell against the Japanese yen and other currencies.

If the price increases persist, they would cause higher prices for gas and groceries.

And rising prices come as the nation's manufacturing sector appears to be contracting, according to the Institute for Supply Management, which surveys manufacturers. Its index, released yesterday, fell to 47.7 in December from 50.8 in November, a worse drop than even the most bearish analysts had predicted. A reading of more than 50 indicates expansion; a reading of less than 50 denotes contraction.

"This is about as bad as it gets," said Joel Naroff, president of the economic consulting firm Naroff Economic Advisors.

Much of the apparent downturn is from deep problems in the housing market. With home construction down, manufacturers are making less lumber, drywall, electrical equipment and other building materials. The decline has been offset somewhat by increased demand for U.S. exports.

The weak manufacturing reading raises the risk of a recession this year, economists said. One part of the survey, new orders received, is a forward-looking indicator. Its descent, economists said, is a sign that the manufacturing environment could get worse in the months ahead.

Other evidence has emerged in the past week that businesses are being more cautious about making investments, which, along with the steep downturn in housing, could lead consumers to have to pull back on spending this year. Orders for durable goods have dropped for two consecutive months.

Given those signs of weakness, a report to be released tomorrow on December employment will be more important than usual, economists said. If companies kept adding jobs, it would be a sign that incomes will hold. "The impact of this report today on the market could be washed away if the job numbers come in okay," Paulsen said. "If they're not, the bad feelings of today are going to be magnified."

The combination of rising prices and a slowing economy have made life difficult for Federal Reserve Chairman Ben S. Bernanke and his colleagues. The central bank tries to maintain price stability and low unemployment, and yesterday's news suggests that it faces difficulties on both fronts.

At the last meeting of its policymaking committee, Fed leaders agreed that interest rates should be cut to stimulate the economy, but they "also recognized that the situation was quite fluid and the economic outlook unusually uncertain," according to minutes of the December meeting released yesterday.

In the view of market participants, the negative news about manufacturing trumped the worries about higher inflation. Based on pricing of futures contracts, the probability that the Fed would cut rates at its meeting Jan. 30 rose yesterday to 88 percent.

If inflationary pressures worsen, the decision could get trickier. "There's really no category that can give them a lot of relief," said Michael Swanson, an economist at Wells Fargo, noting that prices for a wide range of products are on the upswing.

Usually the central bank can fight off inflation by raising interest rates to slow an overheated economy. The sources of inflation now, however, are linked to global trends over which the Fed has little control.

The major reasons for the higher price of oil, for example, include strong growth in China and India, and reduced investment in new drilling when oil prices were low in the late 1990s and early 2000s. Those reasons would not necessarily change if the Fed increased interest rates.

And higher prices for corn are linked to the high price of oil and government incentives for ethanol production.

"Unless the Fed wants to drive the entire world into recession, it ain't going to do a lot about the price of oil," Naroff said. "And unless it takes over Congress, it can't do much about the price of corn."

The Commerce Department said yesterday that construction spending on single-family homes fell 5 percent in November, the largest monthly drop since 1993. Spending on other kinds of construction, mainly commercial buildings, rose more than expected. Private nonresidential construction rose 1.7 percent.