TCS Daily


In for a Shock?

By Kevin Hassett - March 7, 2003 12:00 AM

The employment report that arrived today was about as bad as an employment report can be. The U.S. economy shed 308,000 jobs in February. This decline is the third steepest decline in the past decade. Aside from two similarly-sized declines in the fall of 2001, one has to go all the way back to the terrible recession of 1982 to see job losses as large in any single month. Is the apparent collapse of the labor market a sign that a second recession is underway?

Whenever a weird and troubling data item appears, the first thing one needs to do is to see if there are any unusual circumstances that might explain the bad news. This February there was something going on. About 150,000 reservists were called into active duty, and these ladies and gentlemen were taken off of payrolls when they moved into military service. Since a decline in employment of 100,000 or so could occur in a weak recovery, one might therefore conclude that it is possible that the employment report was not nearly as bad as it first appears. We will not know for sure whether this caused a temporary blip until next month, when the March employment figures will either show a sharp bounce back or not. Between now and then, therefore, we need to rely upon other indicators to evaluate how bad the economy is about to become.

The Federal Reserve has repeatedly referred to "geopolitical risk" over the past six months when discussing the state of the economy. With a war with Iraq imminent, the story goes, businesses and individuals have decided to postpone big-ticket purchases until they have a better idea how bad the war might be. This story makes a great deal of sense, but it is difficult to quantify. Exactly how many lost jobs were attributable to this phantom of dread? It is impossible to say.

One possible method we could use to quantify the impact, however, is to rely upon our old friend the price of oil. As mentioned in this space previously, oil price increases have often led to recessions in the past. These occurred because higher energy costs mess everything up. Consumers have less money to spend on other things. Firms have lower profits, and a reduced desire to purchase machines.

In the current environment, the evidence is chilling. First, the link between oil shocks and recessions is still strong. The price of oil shot up just before the last recession from a low of about $11 a barrel to a high of about $37 a barrel. Near the start of 2002, the price of oil declined sharply, with the price per barrel dropping all of the way down to the teens. At that level, the downward force on economic activity from oil is negligible, and the evidence of that was ample. GDP in 2002 grew at a fairly healthy rate of 2.4 percent. As fear of war with Iraq has become more real over the past 12 months, the price of oil has moved upward fast, retracing the increase that preceded the last recession almost exactly. With the price now closing in on $40 per barrel, another oil-shock recession seems quite likely.

Which suggests that the bad news about job creation in February might well be the start of a run of very negative reports that will ultimately describe a nasty start for 2003. What can turn it around? Clearly, oil prices are high because market participants fear that turmoil in the Middle East could lead to serious disruptions in supply and delivery. If the situation resolves itself quickly, then the oil price reversal will be sudden and sharp as will the economic recovery in the second half of the year.

Last year, we saw two quarters of great growth (the first and third quarters) and two quarters of dismal growth (the second and fourth). If all goes well, it may be that a replay is the best we can now hope for, with the difference being that the bad quarters of 2003 will be adjacent to one another.
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