WEEKLY ECONOMIC COMMENTARY:  WEEK OF NOVEMBER 7, 2008

Having won a bitterly-fought election, the incoming administration will have little time to bask in the glow of victory. Indeed, the honeymoon may already be over for president-elect Obama even before ascending the steps of the White House. Facing a financial market in turmoil and an economy that is deteriorating more rapidly than the disappearance of Sarah Palin's campaign wardrobe, Mr. Obama's is already scrambling to assemble an economic team that will have to hit the road running. This will be no easy task, regardless of the exalted wisdom that the new advisors bring to the office.

To be sure, this will not be the first time that a new administration entered office facing difficult economic challenges. In fact, the last three presidents won their first terms during recessions or when the economy was severely underperforming. The big difference is that they rode to victory on the tail-end of the cycles, whereas this time the worst is probably yet to come. When Bill Clinton and George W. Bush took their oaths of office in January 1993 and 2002, for example, the economy was already on the road to recovery following relatively brief and mild recessions. On January 20, 2009, President Obama will not be so lucky.

By all accounts, the economy is facing more powerful headwinds than the ones that ushered in the last two recessions. While the blasts from these headwinds - particularly the credit crunch and housing collapse - may be easing, the adverse feedback loop is just gaining traction. Simply put, the after-shocks from the headwinds are delivering a severe blow to the economy, and it is unclear how bad conditions will get. Friday's dismal employment report provided the starkest evidence yet of how seriously the economy's underpinnings are falling apart. More than anything, the economy's fate is tied to the job market, particularly now that households are more vulnerable to lost paychecks than any time in recent memory. With home values plunging, the sickening decline in stock prices eviscerating retirement nest eggs and credit either nonexistent or overly expensive, households will need to rely almost exclusively on wages and salaries to sustain purchases.

Unfortunately, there is little comfort in that reliance. For the tenth consecutive month - every month this year - the economy suffered a loss of jobs in October. What's more, the losses are accelerating. In October, nonfarm payrolls plunged by a whopping 240 thousand, about 50 thousand more than expected. That followed on the heels of sharply increased revised losses for each of the previous two months. The revised numbers show that the economy lost 284 thousand jobs in September, well above the 159 thousand initially reported, and 127 thousand in August, a 54 thousand upward revision. Tallying up the damage for the year so far, 1.18 million jobs have been purged from the nonfarm workforce, more than half of which occurred in the last three months alone.

The internal details of the jobs report were as bad as the headline figure. Virtually all sectors of the economy lost jobs except for the demographically driven education and health services grouping. But the cyclically sensitive industries are shedding workers at an increasing pace, and companies are reducing the workweek and shortening the number of working hours. Almost 650 thousand workers were forced into part-time positions last month, raising the total of part-timers to 6.7 million. That's cutting deeply into earnings, which grew by a paltry 0.2 percent in October and 3.4 percent compared to a year ago. Needless to say, worker paychecks are falling well behind the inflation rate.

Nor is the outlook looking any brighter. A leading indicator of future hiring, the change in temporary workers, fell by another 34 thousand in October, following a 28 thousand drop in September. Meanwhile, more people are filing unemployment claims than any time since 1991, and the number collecting benefits for more than one week is the highest since 1983. Reflecting the length of lines at unemployment offices, the jobless rate spiked up from 6.1 percent to 6.5 percent last month. That's the highest since March 1994 and destined to go considerably higher. The consensus forecast is that the unemployment rate will rise above the 7.7 percent peak reached following the 1990-91 recession , and could easily move into the 8-11 percent range, rivaling the peak rates hit during the harsh recession in 1973-75 and the early 1980s.

Keep in mind that the jobless rate typically continues to increase even after the end of a recession for a number of reasons. For one, companies are reluctant to build up their workforces until they are sure that a recovery is in full swing. For another, workers who survived the recession by not getting fired are usually working shorter hours, which are more likely to be beefed up before new jobs are added. Finally, companies tend to enter a recovery with much-impaired balance sheets and are in no position to expand payrolls right away.

So how high can the unemployment rate go? Can it reach the 10.8 percent peak set in the harsh 1981/82 recession, which was the highest in the post-war period? Anything is possible, of course, but we doubt that it will go that high unless policy makers fail to ease the credit crunch. The economic environment then was far more damaged for a longer period of time than is currently the case. Recall also that the expanding baby boom population and the ongoing entrance of women into the workforce boosted the labor force during the 1970s and early 1980s. The combination of a demographically-bloated labor force and the abrupt downturn in economic activity in the early 1980s contributed importantly to the high unemployment rate. That said, it should also be noted that the so-called full employment rate was considerably higher at that time, somewhere in the neighborhood of 6 percent, whereas today it is more like 5 percent. Hence, a 6.5 percent jobless rate "feels" as bad as a 7.5 percent rate would have in the early 1980s.

Given the abysmal state of the job market, is it any wonder that consumers are zipping up their wallets. And it is not just the rank-and-file workers pinching pennies. Whether it is out of guilt towards their more unfortunate brethren, wealthier patrons of luxury establishments are also turning frugal. According to the latest reports from chain stores, the spending pullback is hitting the likes of Saks and Neiman Marcus as well as Target and other outlets that cater to the budget conscious. The exception is Wal-Mart, which saw a rise in sales, largely due to aggressive price-cutting, which is undoubtedly attracting customers out of work or worried about their jobs. However, reports have it that more than a handful of fur-coated customers are clandestinely doing some shopping at places they wouldn't be caught dead in a few months ago. Such is the fate of Wall Street denizens whose bonuses are either being slashed by half or completely eliminated along with their rapidly shrinking job prospects.

Clearly, the upcoming holiday season will be bereft of the usual cheerful spirit associated with more prosperous times. Anxious retailers have already made sure that they would enter the season with lean inventories, knowing that sales prospects have diminished considerably in recent months. Nonetheless, it appears that they still have much more merchandise on shelves than they will need, and are already taking out full-page ads touting sharp price markdowns earlier than is customary. Given the difficulty of getting financing to maintain inventory, that comes as no surprise. Indeed, businesses, both large and small, are finding it almost impossible to obtain credit, something that is the biggest threat to the near-term economic outlook.

For example, according the Federal Reserve's latest Senior Loan Officers Survey, released this week, a record 83.6 percent of banks tightened lending standards for large and mid-sized companies early in the fourth quarter. As the chart shows, that represents a far harsher credit squeeze than either of the last two recessions. Nor are companies finding it any easier to obtain funds from nonbank sources. Trade credit is drying up as suppliers are also in dire financial shape, and larger companies are paying a stiff interest-rate premium in the bond market. Quality spreads have narrowed somewhat in recent weeks, but remain historically wide for investment-grade as well as more speculative issuers. This prohibitive financial climate could not come at a worse time as the need to raise external funds is increasing by leaps and bounds. The gap between cash flow and capital spending of nonfinancial corporations surged to a record $327 billion in the second quarter, more than double that of a year earlier; that gap is likely to grow as the economy weakens, thus further undercutting profits.

As we noted above, the President-elect will have to hit the ground running, and his press conference on Friday clearly left the impression that jump-starting economic growth will be a top priority of the new administration. We suspect that high on the agenda will be another fiscal stimulus package, one that is skewed more towards government spending than tax rebates. There are good odds that something can be passed in the lame-duck session of Congress, including expanding jobless benefits and providing additional aid to struggling state and local governments. Our sense is, however, that much stronger measures will be needed after inauguration day, not only to stimulate growth but to restore confidence in the financial markets, where the damage has been most painfully evident.