By GREG IP
The Associated Press
8/9/04

Oil shocks have accompanied every American recession over the past three decades. Now, this summer's sharp rise in fuel prices appears to be hampering the current expansion, as shown by Friday's weak jobs report.

Oil shocks helped cost two recent American presidents re-election: Jimmy Carter in 1980 and George H.W. Bush in 1992. The 2004 fuel jolt may threaten Mr. Bush's son's bid for a second term as well.

Less than a week ago, George W. Bush was saying, "When it comes to creating jobs for America's workers, we've turned the corner, and we're not turning back." But the news that employers added just 32,000 jobs in July -- the lowest total this year and a sharp deceleration from the spring -- presents the White House with a dilemma: whether to acknowledge trouble (and imply the president's economic measures to date haven't worked so well), or insist the expansion remains on track (and risk appearing out of touch with workers' worries).

With polls showing voters more confident of Democratic challenger John Kerry's economic stewardship, Bush aides are honing a series of economic campaign proposals, discussing everything from simplifying the tax code to adding more tax incentives to expand access to health insurance. Just a few weeks from the Republican convention, President Bush is close to making final decisions on a second-term agenda that will stress economic initiatives under the theme of an "ownership era," according to one adviser.

For Mr. Bush, who argues passionately that the economy is strong, being put on the defensive now must seem a cruel irony: Economic data released after the fact showed that the economy in 1992 had begun its long boom when the voters, not sensing that yet, booted his father from office.

Oil shocks also make life difficult for the Federal Reserve, which has been planning a slow, steady step-up in short-term interest rates over the coming months. When Fed policymakers meet tomorrow, they are thought likely to stick to plans to raise the short-term rate for the second time this summer. But they will also debate whether to continue that course through the fall. Oil prices, which briefly hit an all-time high (not adjusted for inflation) of $44.73 early Friday, may be doing the job of curbing consumer demand for them. But they could also lead to higher inflation if workers win compensating wage gains.

Few forecasters suggest the U.S. is tipping back into recession. There have been plenty of upbeat numbers to offset the recent weak data. Auto sales rose smartly in July. Consumer confidence numbers remain high. And some measures suggest the job picture isn't so bleak. While Friday's labor-market report showed weak job creation in July, it also showed a modest gain in factory payrolls, a longer work week, decent pay gains and a drop in the unemployment rate to 5.5 percent -- the lowest level in nearly three years.

Still, economists and some investors aren't nearly as bullish as they were when the summer began. A month ago, Macroeconomic Advisers LLC was projecting growth in the current quarter of 5 percent. Now, the widely followed St. Louis forecasting firm is estimating just 3.6 percent. After the Dow Jones Industrial Averaged plunged 147.7 points to 9815.33 on Friday, the blue-chip indicator is down 7 percent from its high this year, a poor performance this early in an expansion.

High oil prices aren't the only thing weighing on the market and the broader economy. Another factor is the fading effect of the stimulus policies that were designed to counteract the 2001 recession and sluggish recovery. Some economists believe consumers needed the steroids of repeated tax cuts and successive rounds of mortgage-refinancing to sustain their remarkable spending binge from late 2001 through the spring. With that stimulus now wearing off and Treasury and the Fed in no position to administer more, consumers may finally be retrenching partly in response to the high debt levels they've taken on in recent years.

This year's surge in oil prices isn't as dire as the shocks of the 1970s. In constant 2004 dollars, today's price is still some 40 percent below the record price hit in 1981. And the U.S. is more fuel-efficient than it was back then. However, the doubling of petroleum prices since early 2002 still represents one of the largest sustained increases since 1979 and has significantly crimped disposable income for consumers.

Average hourly wages advanced a respectable 0.3 percent in July from June. But adjusting for the most recent 3.3 percent inflation rate -- a figure boosted largely by current energy prices -- purchasing power has fallen 1.3 percent from a year earlier, the biggest such drop since 1991.

This appears to be a leading factor in recent sluggish retail sales, especially among stores serving less-affluent consumers. "For the low- to middle-income consumer, higher gasoline prices take a larger percentage of their disposable income," notes George Mahoney, executive vice president at Family Dollar Stores Inc. The Matthews, N.C., chain reported sales rose just 1.4 percent in the four weeks ended July 31 from a year earlier, at stores open at least a year. "We see the impact not on the basic consumables -- household chemicals, paper products, food," Mr. Mahoney adds, "but on the more discretionary items, such as ... giftwear, sheets, towels, pillows."

As energy costs rise, "you feel kind of helpless," says Michael Nagy, who works for the San Diego Regional Chamber of Commerce. Mr. Nagy drives about 130 miles in his daily commute and now spends some $60 a week to fill up his tank. To compensate for the added fuel expense, he and his wife eat out less, scrimp on home heating or air conditioning, and search for grocery-store sales. The 32-year-old Mr. Nagy also wants to trade in his V-6 Chevrolet Malibu for "something that gets 30 miles to a gallon."

Weakness in consumer spending may now be ricocheting into job growth. The retail and hospitality industries were two principal job losers in July. Both are sensitive to consumer discretionary spending. Retailers shed a net 19,000 jobs (including 2,600 at gasoline stations), while employment in leisure and hospitality fell by 2,000.

Indeed, there are troubling signs that the business caution about investing and hiring that restrained the economy from 2001 to mid-2003 might be returning. Software companies reported a sudden falloff in orders in late June. And the growth in capital-equipment orders appears to have eased.

The new softness in the labor market risks creating a vicious circle of weakening growth. The economy's "only tailwind was significant employment growth," says George Magnus, an economist at UBS AG. "Without it, we're facing an uphill task."

Oil remains the leading risk to the U.S. economic outlook. And barring a sudden easing of geopolitical worries, significant short-term relief seems unlikely.

Earlier oil-price run-ups were primarily caused by a withdrawal of supply, or fear of one. This time around, most of the increase results from strong demand, especially in fast-growing China. World oil consumption is expected to grow by 3.2 percent this year, or 2.5 million barrels a day, according to the International Energy Agency. Growth was generally around 2 percent or less for most of the prior decade.

Of course, a strong global economy is mainly good for the U.S., giving exporters a much-needed boost. And manufacturers added 10,000 jobs in July.

But the strong global demand for oil has left the petroleum industry with almost no spare capacity to cushion any disruptions in supply, which has been growing far more slowly than demand. The world's oil producers are thus operating with a tiny margin of spare pumping capacity of just one million barrels, in a market of 80 million barrels a day.

That, in turn, means, any supply problems could send prices skyrocketing. Last week's jump was driven by concerns that Russia's OAO Yukos will be forced to suspend production -- a situation that shifts almost daily as Moscow pursues the oil giant's unpaid back taxes and prosecutes its former chief, Mikhail Khodorkovsky. Oil prices jumped again Friday on news of a refinery fire in Texas, before retreating.

Another force driving oil prices higher is turmoil in the Middle East. That factor means prices could fall just as sharply as they rose, if fears of instability were calmed. But it also risks raising the political damage to President Bush. To the extent voters connect the dots, they may combine two of the American public's main concerns about Mr. Bush -- an uncertain economy and instability in Iraq -- into one big one.

Mr. Kerry, touting his energy plan in Missouri Friday, did his best to link the two. "We are at war, a war on terror, where much of the focus of that war is in the Middle East," he said. "Guess what else is in the Middle East," he added. "Oil." Kerry campaign advisers assert that the "terror premium" has added as much as $15 to a barrel of oil, higher than many private estimates. "Instability and danger in the Middle East are driving up the price of oil," Mr. Kerry said in another recent speech. "Higher premiums weaken our economy and risk our security," he added. "But it doesn't have to be this way."

As a short-term response to high oil prices, Mr. Kerry has called on the White House to suspend daily additions of about 100,000 barrels a day to the Strategic Petroleum Reserve, a reservoir set up after the 1970s oil shocks to protect against future supply disruptions. Some White House advisers favor such a move. Mr. Bush has steadfastly refused those suggestions, saying that the reserve must be filled to guard against emergency situations.

Yet the fresh signs of a slowing pace of expansion require some kind of White House response. The bad job news in particular poses acute risks to Mr. Bush's re-election, since job concerns eclipse other economic issues in voters' minds. Moreover, the states with the worst job markets are the very battleground states, mostly in the Midwestern industrial belt, that he and Mr. Kerry are fighting over most intensely. "It's not what we would have hoped for this close to the election," says Republican strategist Jeff Bell. And time is running out to change voter perceptions: There are just two more monthly job reports before Nov. 2.

Mr. Bush's first challenge is what to say -- acknowledge that there's a problem, or ignore it. Both carry big risks in an election season. His father, doggedly making a case that the economy was improving, looked out of touch in 1992, contributing to his loss to Bill Clinton. It was little consolation when revised government data later confirmed that he was correct. For now, one adviser to Mr. Bush says the latest job data "won't make a difference" in either the president's rhetoric or his actions. Indeed, top administration officials labored to portray Friday's report as good news. "The economy is back on track," Vice President Dick Cheney declared on Friday in East Grand Forks, Minn. Mr. Bush, the same day, said, "Economic growth is strong and it's getting stronger," though he seemed to have dropped his line about the job situation having "turned the corner."

Gregory Mankiw, chairman of Mr. Bush's Council of Economic Advisers, said in an interview, "I'm not satisfied with the payroll employment data." But, like many Republicans, he noted that the Labor Department's more volatile survey of households showed employment gains of 629,000 in July (though 30 percent were part time). The two surveys diverge in part because they measure employment differently. The household survey, for example, found an increase of 175,000 among the self-employed in July, which the payroll survey doesn't measure. Republicans highlight the household survey because it shows 1.9 million more jobs since Mr. Bush took office, while the payroll survey shows a loss of 1.1 million. But most economists, including Mr. Greenspan, consider the household survey less reliable because it is based on a far smaller sample.

Mr. Mankiw added, "Oil prices are clearly a drag on the economy. Price spikes have been associated with economic downturns in the past, (so) whenever oil prices spike up, one starts worrying." Still, he noted conventional economic models find that even a $10 increase in crude-oil prices per barrel trims just a third of a percentage point off annual growth.

The other challenge facing Mr. Bush is what, if any, policy actions to take. Even before the latest economic reports, the White House was in the midst of an internal struggle over whether to produce an ambitious second-term economic agenda -- so far lacking -- as part of the re-election campaign.

The president, attending a family wedding at the Bush compound in Kennebunkport, Me., over the weekend took some policy options to study. A top adviser says Mr. Bush is inclined to propose major economic initiatives, figuring that "elections are about the future, not the past."

The theme of the proposals will be about creating "an ownership era." As part of that, Mr. Bush is likely to stress homeownership, creating private retirement accounts as part of Social Security and simplifying the tax code. He might propose giving individuals and businesses tax incentives for health insurance and for the production and use of alternative energy sources, among other things.

For the past month, economic advisers have been vetting all sorts of potential tax-code variations. The adviser said Mr. Bush was likely to propose "tax-code simplification" in general terms, perhaps directing his administration or a commission next year to recommend changes -- much as Ronald Reagan did amid his 1984 campaign, giving rise to the landmark 1986 tax-reform act.

While Mr. Bush wrestles with the political fallout of the softening economy, Fed Chairman Alan Greenspan is struggling with the policy implications. In June, the Fed began what it thought would be a series of quarter-point increases in the federal-funds rate, the rate on overnight loans among banks. That would raise it from the unusually low 1 percent earlier this year to a "neutral" level (probably between 3 percent and 5 percent) that would neither stimulate nor retard growth. The rate is currently 1.25 percent.

Fed officials were prepared to tolerate fluctuations in economic growth as they proceeded, believing the risk of breeding inflation later on by leaving rates low exceeded the risk of aborting the expansion with tighter credit. When job growth and consumer spending softened in June, Mr. Greenspan said it was a "soft patch" that would prove "short-lived."

The latest job numbers surprised the Fed much as they surprised Wall Street, raising the possibility that the soft patch may be something more ominous. So far, there is enough offsetting evidence for the Fed to stick with its view that the economy will grow solidly in the second half. On Tuesday, it is likely to raise its federal-funds target to 1.5 percent. If August data suggest the soft patch is indeed ending, the Fed would likely raise it again on Sept. 21, its last meeting before the Nov. 2 election.

But Friday's jobs data prompted some on Wall Street to speculate the Fed will convey a more worried economic outlook in the statement following its meeting Tuesday. That would leave the door open to pausing in its program of "measured" rate increases, perhaps in September.

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