WASHINGTON — The U.S. economy shriveled at the end of 2008, shrinking by the most in 26 years as consumers and businesses cut spending, the housing slump deepened, and exports plunged, according to data also showing prices tumbling amid a deepened recession.

Gross domestic product fell at a seasonally adjusted 3.8% annual rate October through December, the Commerce Department said Friday in the first estimate of fourth-quarter GDP.

Third-quarter GDP fell 0.5%. The back-to-back GDP drops were the first since GDP fell 3.0% in the fourth quarter of 1990 and 2.0% in the first quarter of 1991.

While the 3.8% decline marked the weakest GDP performance since a 6.4% drop in first-quarter 1982, it was smaller than expected. Economists surveyed by Dow Jones Newswires forecast a 5.5% drop in GDP during the last three months of 2008.

Federal government spending helped the economy — but not by as much as in the third quarter. Also preventing the economy from sinking further were inventories, which rose at the end of 2008. On a down note, the inventory increase was likely unintended — the result of companies getting stuck with unwanted merchandise because demand has tailed off in the recession. Excess inventory will have to be worked off down the road and that signals production cuts, which in turn could mean layoffs, hamstringing the economy even more.

Gauges measuring prices were way down. For instance, the price index for personal consumption expenditures dropped by 5.5% after increasing 5.0% in the third quarter. The PCE price gauge excluding food and energy rose 0.6%, after increasing 2.4% in the third quarter.

GDP acts as a scoreboard for the economy by measuring all goods and services produced. Its biggest component is consumer spending, which dropped by 3.5% in the fourth quarter. That was better than the 3.8% drop in the third quarter.

Purchases of durable goods plunged 22.4% in the fourth quarter, after decreasing by 14.8% in the third quarter. Fourth-quarter non-durables spending fell by 7.1%. Services spending climbed 1.7%.

Overall, consumer spending reduced GDP by 2.47 percentage points; it had deducted 2.75 percentage points in the third quarter.

Another component of GDP, housing, took a bite out of the economy. Residential fixed investment plummeted by 23.6%, reducing overall GDP by 0.85 of a percentage point. Third-quarter investment fell by 16.0%, taking 0.60 of a percentage point out of GDP.

International trade gave just a tiny boost to the economy, after six straight quarters of strong support. U.S. exports fell by 19.7%, the most since 19.9% in third-quarter 1974. Imports also fell, reflecting the economic weakness of the big trading partners of the U.S., decreasing 15.7% in the largest drop since 1980. All in all, trade wound up contributing 0.09 of a percentage point to GDP. That was the softest showing since trade deducted from the economy in first-quarter 2007, reducing GDP back then by 1.20 percentage points.

Business spending plunged 19.1% in the fourth quarter, after decreasing by 1.7% in the third quarter. The drop was the biggest since 22.4% in first-quarter 1975. Investment in structures went down 1.8% in the fourth quarter and equipment and software outlays decreased 27.8%.

Inventories increased by $6.2 billion, after going down $29.6 billion in the third quarter and $50.6 billion in the second quarter. Inventories added 1.32 percentage points to GDP in the fourth quarter.

Real final sales of domestic product, which is GDP less the change in private inventories, decreased 5.1% in the fourth quarter, after falling by 1.3% in the third quarter.

Federal government spending increased 5.8%, after rising in the third quarter by 13.8%. State and local government outlays fell 0.5%, after going up by 1.3% in the third quarter.

Other price inflation gauges in the report include the price index for gross domestic purchases, which measures prices paid by U.S. residents. It fell 4.6%, after increasing 4.5% in the third quarter. The chain-weighted GDP price index decreased 0.1%, after increasing 3.9% in the third quarter.

By Jeff Bater
Of DOW JONES NEWSWIRES

The handful of U.S. bond-fund managers who avoided last year’s market bloodbath by hiding out in Treasurys now say they favor owning corporate and mortgage bonds and selling U.S. government debt.

PIMCO, Vanguard, Morgan Stanley and First Pacific Advisors funds that gained from about 5% to a stunning 49% while the Standard & Poor’s 500 stock index plunged 37% last year are inclined to take a bit more risk.

They’re sticking to mortgage-related debt and other bonds supported by the Treasury or the Federal Reserve. And they are cautiously buying corporate bonds.

“Investment-grade credit is very attractive,” said Gregory Davis, head of bond indexing at Vanguard and portfolio manager for its Long-Term Bond Index Fund (VBLTX). The fund gained 8.6% in 2008, making it one of the top-performing U.S. bond funds last year, according to investment researcher Morningstar Inc.

For corporate bonds, “a lot of bad news is priced in, including defaults and downgrades,” Davis said.

Top-performing fund managers are selling or paring their holdings of U.S. Treasurys, one of last year’s best-performing assets. The $2 trillion in new bonds the Treasury is expected to issue this year will likely weigh on prices.

Meanwhile, other government programs to bail out the credit markets, say by guaranteeing bank debt, will make Treasurys less attractive, managers say.

“As policy maneuvers are implemented and make the way through the system, prudent investment managers are going to be reducing their risk-free exposure and going more towards risk products,” meaning anything besides Treasurys, said Steve Rodosky, manager of PIMCO Long Duration Total Return Fund (PLRIX), which gained 12.4% last year.

By comparison, the Barclays Capital U.S. Aggregate Bond Index rose 5.24% in 2008. A wide range of bond funds took huge losses as volatility and illiquidity in credit markets made trading dicey, and investors fled most assets in favor of the safety of Treasurys — slamming holdings in corporate debt, mortgages and even municipal bonds.

If more investors follow these managers’ strategy into corporate debt and mortgages and out of Treasurys, the government will end up paying more to finance its growing deficit. And investors who have hung onto Treasurys bought in the current rally could see their portfolios take a nosedive.

Copying The Fed

One strategy that successful managers say has some legs is to buy debt that the government is also buying.

That strategy lends itself to holding mortgage-backed securities and debt sold by the big housing finance agencies including Fannie Mae (FNM), Freddie Mac (FRE), Ginnie Mae and the Federal Home Loan Banks.

The Fed has purchased $24.6 billion in agency debt since December, and aims to buy up to $100 billion, in the hope of lowering mortgage rates and reviving the housing market.

First Pacific Advisors’ New Income Fund (FPNIX), which rose 4.8% last year, is keeping the biggest chunk of its cash in mortgage-backed securities.

Thomas Atteberry, who helps run the fund and was named Morningstar’s fixed-income manager of the year for 2008, plans to keep that segment around 42% of the fund. He also has about 20% of the fund in agency debt. Both benefit from having the Fed as a major buyer, in addition to the government taking over Fannie and Freddie last year, effectively guaranteeing those entities.

“The Fed will keep those capitalized because it needs the institutions to implement policies in the mortgage space,” Atteberry said.

Companies that are explicitly benefiting from policy actions are likely to have the best opportunities, said Rodosky, who also manages the PIMCO Extended Duration Fund (PEDIX). That fund gained 49% last year, predominantly by holding Treasury and agency zero-coupon bonds that perform well in a declining rate environment, he said.

Debt sold by banks that is guaranteed by the Federal Deposit Insurance Corp. should do well, he said.

Also, debt sold by firms that have issued FDIC-backed notes but trade on their own rating have good potential relative to the risk involved, he said.

Goldman Sachs Group Inc. (GS), Citigroup Inc. (C) and Morgan Stanley (MS) have issued FDIC-backed bonds.

Still, “there are going to be some losers in this process, despite the government guarantees,” he said. Several institutions are likely to be consolidated.

“Not every bond out there is money good,” he said.

Company Debt Looking Better

Several managers recommended investment-grade debt, rated at least Baa by Moody’s Investors Service or BBB by Standard & Poor’s, saying the yield compared to benchmark Treasurys is advantageous.

Corporate bonds rated A or higher carry yields 4.66 percentage points over Treasurys, according to an index compiled by Merrill Lynch. That spread skyrocketed to as much as 5.90 points in early December, after generally being below 1.5 points until late 2007.

Wide spreads mean there’s a good opportunity for those bonds to improve as the gap narrows, Vanguard’s Davis said.

“If we see even a stabilizing economy, we can see outperformance in this sector,” he said.

Part of Vanguard’s gains can be attributed to engaging in less trading than more actively-managed funds, because it’s designed to match the characteristics of the Barclays Capital U.S. Government/Credit Bond Index, Davis said.

That Barclays index rose 5.7% in 2008.

In matching the index, the fund’s biggest holdings include General Electric Co. (GE) and AT&T Inc. (T).

GE’s bonds, rated AAA, sold off sharply last year as a broader crisis of confidence led investors to demand higher yields on all company debt, but ended 2008 much closer to where they started.

David Armstrong, who helps oversee the Morgan Stanley Long Duration Fixed Income Fund (MSFIX), also has focused on companies that have conservative operating and financial leverage and are able to withstand a severe recession.

“It is hard to judge the depth and duration of the economic contraction so we are concentrating on credit quality,” Armstrong said.

The fund returned 10.9% in 2008. It started last year with about 30% in corporate bonds, less than its benchmark, anticipating more weakness in the economy than many others were positioned for. The fund is now up to 45% in company debt, largely through the addition of high-quality industrial names, he said.

He noted a number of high-quality issuers have issued debt recently, including Wal-Mart Stores Inc.(WMT), McDonald’s Corp. (MCD) and Emerson Electric Co. (EMR).

Treasury Rally Over

Bond managers expressed the most distaste for Treasurys, which helped several avoid the market’s pitfalls last year. They expect Treasury bond prices to fall, pushing yields up, hurt by the same policies that help other assets. The government is incurring a lot of debt by buying other securities and propping up financial markets, let alone the massive economic stimulus package expected to be approved in the next month or so.

“We’re going to see rates back up on the longer-dated paper,” Davis said. “There is a lot of supply to be digested.”

Still, uncertainty about the economic outlook for 2009 has First Pacific Advisors’ Atteberry cautious.

Enough policy questions remain to keep him from aggressively adding to holdings he already had.

For example, legislation to amend bankruptcy laws to allow judges to change mortgage terms could wreak havoc for the mortgage market, where investors focus intently on how long a given mortgage will be outstanding or be refunded.

Also, speculation that the government wants to help a lot of home purchasers lock in mortgage rates close to 4.50% for 30 years means those owners will have little incentive to move, also affecting how long a mortgage will actually be outstanding, Atteberry said.

“These are fundamental changes to the rules of the mortgage space, so prudence tells you to back away,” he said.

Reflecting that view, the fund has about 31% in cash or cash equivalents, he said.

“There are a lot of policy moves and I think people should wait and see what the rule changes look like,” Atteberry said.

By Deborah Levine

 Federal and state authorities are reporting a growing number of financial scams that echo the alleged Madoff fraud, as strapped investors seek access to their cash amid increasingly hard times.

At least six suspected multimillion-dollar fraud cases have emerged this month alone, many of them alleged Ponzi schemes, in which investors are lured by promises of lofty returns but are actually paid off from new victims’ funds.

On Tuesday, authorities arrested Arthur Nadel, the missing Florida hedge-fund adviser, who was accused by federal authorities of defrauding clients of millions of dollars. His arrest came as Spanish banking giant Banco Santander SA said it would offer thousands of its private-banking clients 1.38 billion euros ($1.82 billion) in compensation for losses arising from investments in Bernard L. Madoff’s alleged $50 billion Ponzi scheme, the first financial company to do so.

Todd Foster, a lawyer for Mr. Nadel, says his client voluntarily surrendered to the authorities and is cooperating with them. He says “we aren’t in a position to comment on the criminal charges now,” adding that investment “losses don’t necessarily equate with fraud.”

In the latest case to emerge, Nicholas Cosmo, a Long Island, N.Y., investment-firm owner, surrendered to federal authorities Monday. Mr. Cosmo allegedly raised more than $370 million between 2006 and 2008 by promising investors 48% annual returns from funding commercial loans, according to a federal affidavit in support of his arrest.

But little money was lent, and only about $746,000 remains, according to the federal affidavit. According to his attorneys, Mr. Cosmo intends to work with authorities “to allay investors’ concerns.” A federal judge in New York’s Eastern District ordered him held pending a bail hearing Thursday.

The rise in financial-fraud reports preceded the Madoff case’s emergence. A review of recent Securities and Exchange Commission civil actions shows an increase in cases in which the agency alleged Ponzi schemes. The agency, which doesn’t keep an official count, brought at least 23 Ponzi cases last year, up from 15 in 2007. It has already filed four in 2009. That tally doesn’t include actions on the state level, where allegations of securities fraud are routinely pursued. The SEC declined to make anyone available to discuss its Ponzi cases.

More schemes are emerging now, experts say, in part because of the economic downturn. Tough times have prompted people to seek to cash in their investments, only to find out their money is missing. New investment also dries up in slumps, making it harder for fraudulent funds to replenish their coffers and make the payments needed to keep their operations going.

The recent economic boom may have made some investors especially susceptible to Ponzi schemes and other investment frauds, investigators say. That’s because legitimate but secretive hedge funds and other investment firms reported years of strong gains, making eye-popping returns seem more plausible.

“When you have serious economic problems, people who have been content with where their money has been sitting sometimes need it,” says Bill E. Branscum, a private investigator in Naples, Fla., who has probed dozens of Ponzi schemes. “And in needing it and in finding out that they can’t get it, that serves to reveal Ponzi schemes that may have gone unnoticed.”

Three weeks ago, the SEC accused a Philadelphia-area investment fund manager, Joseph S. Forte, with running a Ponzi scheme since at least 1995 that claimed returns as high as 38% and raised $50 million. Mr. Forte didn’t return phone calls made late in the day.

Meanwhile, Idaho’s securities regulators are investigating allegations by investors in Idaho Falls that they lost up to $100 million in an alleged Ponzi scheme by Daren Palmer, a local money manager. No charges have been filed. Mr. Palmer didn’t return phone calls made late in the day.

There was also the case of Marcus Schrenker, an Indiana financial adviser who was arrested in Florida earlier this month after allegedly trying to stage his death in a plane crash as investigators probed his businesses. He faces charges in Indiana and Florida; his lawyer has said Mr. Schrenker isn’t mentally competent to stand trial in Florida.

The biggest case, of course, is the one allegedly carried off by New York money manager Mr. Madoff, who has estimated inflicting losses of $50 billion on his investors. Mr. Madoff’s attorney, Ira Lee Sorkin, declined to comment.

In scale, all of the SEC’s other alleged Ponzi cases pale in comparison with Mr. Madoff’s alleged scheme, which lasted for decades. The second-largest SEC case last year, one that the agency says primarily targeted Orthodox Jews, totaled about $255 million, according to SEC records. Excluding the Madoff case, the alleged schemes cited in the past 13 months generated more than $1.1 billion from unsuspecting investors, according to SEC records.

The Ponzi scams alleged by the SEC sprung up all around the country: in Texas, where participants, many of them elderly, invested $45 million in a phony hedge fund that supposedly produced annual returns as high as 61%; in a currency-trading scheme in Georgia which promised returns of 10% a month; in Florida, where two companies raised $30 million by allegedly convincing investors they would earn money by exporting gadgets like Apple iPods to South America. The SEC alleges that the companies purchased few electronics and used “newly invested funds to make principal and interest payments to existing investors.”

An attorney for the defendant in the Texas case, Rod Cameron Stringer, had no comment. An attorney for the defendant in the Georgia case, James G. Ossie, said his client “hasn’t yet responded to the allegations of the government” but that “he’s been cooperating with regulators and wants to make restitution to all his clients.” The defendant in the Florida case, Andres Pimstein, pleaded guilty last month to related criminal charges of wire fraud “in connection with a multi-million dollar investment “Ponzi” scheme,” according to the Federal Bureau of Investigation. Mr. Pimstein couldn’t be reached for comment.

According to SEC filings, many of the alleged victims in the agency’s cases believed they were receiving huge returns from exotic investments, including hedge funds, private placements of securities and foreign notes.

Ponzi operators “always need a disguise,” says Robert L. FitzPatrick, a Charlotte, N.C., consultant and expert on Ponzi and pyramid schemes, a similar form of ruse in which investors lure other investors. “It normally includes some kind of rather vague description of the way it earns money.” He notes that legitimate hedge funds,which are lightly regulated, generally lack transparency.

Ponzi scheme’s namesake, Charles Ponzi, a Boston-based con man, peddled an exotic investment. Mr. Ponzi raised millions of dollars in 1920 by promising 50% returns in 45 days by exploiting exchange-rate discrepancies in international postal coupons, used to buy stamps. But authorities said he wasn’t even buying the coupons; he later pleaded guilty to mail fraud.

In many of the SEC cases, the perpetrators allegedly siphoned off money to fund lavish lifestyles. An SEC civil complaint last year accuses a California investment adviser of using millions of his clients’ money “to pay for lavish personal expenses, such as upkeep on his Ferrari, limousine services and shopping trips.” The defendant, Robert C. Brown Jr., of Hillsborough, Calif., couldn’t be reached for comment late in the day.

The SEC has accused South Florida investment adviser Anthony A. James of misappropriating at least $2.4 million in client funds to buy a six-bedroom home, a Porsche and season tickets to the Miami Heat basketball team. In that case, filed in September, the SEC alleges that between 2001 and January 2008, Mr. James, principal of James Asset Advisory LLC, received at least $5.2 million from about 44 clients who were told their money would be invested in stocks, bonds and mutual funds.

The SEC alleges the money never was invested. Instead, the agency says, Mr. James misappropriated at least $2.4 million for personal expenses. They also say that “like a classic Ponzi scheme,” he and his company “transferred approximately $2.8 million from new clients to existing clients to repay principal or to create the illusion of profitable trading.”

Bruce M. Lyons, Mr. James’s attorney in the SEC case, says his client doesn’t dispute the allegations and that he’s “trying to arrange to make everybody who was involved in the transactions whole.”

By Steve Stecklow
OF THE WALL STREET JOURNAL

NEW YORK — During most of the last expansion, U.S. consumers saved almost nothing from their current incomes. Conspicuous shopping was all the rage; soaring home values and stock prices made people feel wealthier.

But the current recession has changed that mindset. And as U.S. households add more to their nest eggs, the economy will have to adjust to reduced consumer demand.

If so, expect more store closings, bankruptcies and retail job layoffs. Other discretionary industries, from restaurants to casinos to tourism to health spas, will also feel the brunt of the new urge to save. Financial planners and banks may benefit. But investors, once burned by Wall Street, may be reluctant to buy stocks and bonds any time soon.

According to Bureau of Economic Analysis data, U.S. households saved less than 1% of their disposable income from 2005 until April of 2008 — far below the 10% posted in the early 1980s. (Data from the Federal Reserve Board make the situation look even worse: Personal savings, excluding investment in durables, fell into negative territory in 2005 and 2006.)

But despite the meager additions to their nest eggs, households still got richer, at least on paper. Fed data show that household net worth rose by more than $10 trillion in the three years ended in 2007. Direct holdings of equities and mutual funds jumped $3.4 trillion, real estate values rose $1.9 trillion, and credit-market instruments increased more than $800 billion.

In effect, U.S. consumers found a way to have their cake and eat it, too.

Of course, there were other reasons besides soaring asset values for the dearth of savings.

Because the developing world was socking away money religiously, there was a global savings glut. The U.S. government didn’t have to depend on its own citizens to fund huge fiscal deficits when foreign central bankers and sovereign wealth funds were willing to buy Treasury debt. The U.S. economy could increase its current account deficit thanks to investors worldwide.

In addition, in a world of aspirational retailers, product placement in media, and heavy advertising overall, households developed a preference for grasshopper-esque shopping over ant-like saving.

A team of three economists looked into why the national saving rate fell in recent decades, not just in the U.S. but also in France and Italy. They found that each society began to feel less obligated toward leaving capital to future generations. In the economists’ view, the savings rate in each country would have been much higher “had American, French, and Italian societies not become so focused on immediate gratification.”

In other words, we devoted more money to iPods, less to IRAs.

But then the housing and stock markets crashed. From the end of 2007 until the third quarter of 2008, household wealth shrank by $5.6 trillion.

Faced with disappearing 401k retirement accounts, plummeting home prices and a recession that has stolen away millions of jobs and cut into salaries, consumers are salting away more cash. By November, the U.S. savings rate had edged up to 2.8%.

It is very likely the rate will keep rising since consumers tend to save more during recessions. Financial advisers are telling clients to have a nest egg equal to six months of expenses in the event of a layoff. Hoarding has become fashionable.

That’s why last summer’s rebate checks failed to stimulate the economy. Few taxpayers spent the money; most saved the cash or used it to pay off debts.

And it is why many retailers are struggling. The U.S. economy is organized around the consumer as growth engine. That will no longer be the case in coming years as households adjust to a new financial reality.

Alan Levenson, chief economist at T. Rowe Price Group Inc. (TROW), estimates that the rise in savings in the fourth quarter accounted for the roughly 6.5-percentage-point wedge between the annualized growth rates of nominal after-tax income (down 1.1%) and nominal consumption (down 7.7%).

Levenson writes that “the spike in financial market and economic uncertainty likely encouraged caution generally.”

As a result, he forecasts that the savings rate will rise about two percentage points per year to hit between 6.5% and 7.0% by the end of 2010. That would be the highest yearly savings rate since 1992.

If one assumes the recession holds disposable income flat in 2009 (with the expected tax cuts offsetting earnings lost through layoffs) and income grows about a very modest 2% in 2010, the new additions to savings would shift about $400 billion away from consumer spending over the next two years.

In the short run, the shift to savings will be tortuous for all those who depend on consumer spending. But in the long run, a higher savings rate will be a good thing. It will be the only way that the U.S. can finance the retirement of the baby-boom generation, whittle down its massive current account deficit, and pay down the humongous federal deficits that are coming our way.

By Kathleen Madigan
A DOW JONES NEWSWIRES COLUMN

 WASHINGTON — U.S. consumer prices barely rose last year by their slowest pace in over a half century, a government report showed, a stunning turn just a few months after inflation hit 17-year highs.

Much of the reversal was due to a roughly 75% decline in oil prices from their July peak that has in turn brought prices down for everything from gasoline and home heating to airline fares.

But some of inflation’s disappearance is also a consequence of the severe economic recession that is causing nervous households to delay spending, which in its worst form could lead to the type of deflationary spiral that gripped Japan in the 1990s.

The consumer price index dropped 0.7% in December on a seasonally adjusted basis compared to the previous month, the Labor Department said Friday, after falling at a record pace in November. Economists had expected a 0.8% decline.

The core CPI was unchanged. Economists had expected a slight rise.

Unrounded, the CPI fell by 0.737% last month, the fifth drop in a row. The core CPI fell 0.015% unrounded.

Consumer prices rose just 0.1% compared to December 2007, the lowest calendar-year increase since 1954 and well below the Fed’s 1.5% to 2% preference over the long run. The CPI swelled 4.1% in 2007. The core CPI, in contrast, was up 1.8% last year, though it did fall 0.3% on an annual basis during the fourth quarter.

Federal Reserve officials have in recent days downplayed the chances of deflation, though they’ve also said inflation should moderate further. “It seems likely that inflation will move, for a time, below levels that are consistent with price stability,” San Francisco Fed President Janet Yellen said Thursday, though she said she is confident any deflationary forces can be contained.

Some Wall Street economists think changes in the CPI will soon turn negative on an annual basis given the weakness of the economy and the sharp increases that occurred in early 2008.

“We will have to wait a further month before we get headline deflation,” said ING Bank economist Rob Carnell, in a note to clients. “But it is coming and may get down to as low as -3%” on an annual basis unless oil prices reverse their recent declines, he said.

As long as price declines stay centered in energy and commodities, it’s largely a plus for the U.S., especially since it imports most of its oil from abroad. It’s when those declines get embedded more broadly in inflation expectations and cause consumers and business already facing a weak economy to delay spending, hiring and production that they become an economic headache.

And there are early signs that may be occurring. Industrial production fell 2% on a monthly basis in December, the Fed said, almost double the decline economists had expected. Nearly all categories in the report, from technology to cars to clothes, showed falling output, pushing the capacity utilization rate to well below its hitorical average.

“The manufacturing sector is mired in very deep recession,” Insight Economics analyst Steven Wood said.

The Fed has already lowered rates to near zero to prevent a deflationary spiral from occurring. The CPI data give the Fed even more latitude to use its balance sheet to stabilize the financial system without worrying about the inflationary effects.

The recent plunge in price pressures has also breathed new life into the once-dormant inflation targeting debate. In the minutes of their December meeting, Fed officials said an explicit inflation objective “might help forestall the development of expectations that inflation would decline below desired levels.”

According to Friday’s report, energy prices tumbled another 8.3% in December compared to November and plunged 21.3% for 2008 as a whole, the largest annual decline ever. Gasoline prices plummeted 17.2%.

Food prices slid 0.1%. Food and beverage prices were flat.

Transportation prices fell for a third month in a row, by 4.4%, as airline fares dropped 1.2%. New vehicle prices fell 0.4% in December and 3.2% for 2008 as a whole, the biggest drop since 1971, reflecting the severe slump in auto sales.

Housing, which accounts for 40% of the CPI index, was unchanged. Rent increased 0.2%. Owners’ equivalent rent advanced 0.1%. However household fuels and utilities prices tumbled 0.5% while lodging away from home fell by 0.7% as households cut back on non-essential spending. Recreation, another discretionary item, also fell in price.

Medical care prices increased 0.3%, while clothing prices fell 0.9%, which may reflect holiday discounting that the most recent Fed Beige Book called “sizable.”

In a separate report, the Labor Department said the average weekly earnings of U.S. workers, adjusted for inflation, climbed 0.6% in December as higher wages and falling prices offset a decline in hours worked.

By Brian Blackstone
Of DOW JONES NEWSWIRES

WASHINGTON — U.S. producer prices fell for a fifth-straight month in December on steep declines in energy and food prices, suggesting that inflationary pressures continue to recede rapidly as the economic recession deepens.

Wholesale prices fell 0.9% for 2008 as a whole, the biggest calendar-year decline since 2001, capping a stunning reversal in which the PPI went from near double-digit annual rates to below zero in the space of only four months.

The producer price index for finished goods plunged 1.9% on a seasonally adjusted basis, the Labor Department said Thursday, in line with Wall street expectations.

The core PPI, which excludes food and energy, advanced 0.2% last month, slightly above expectations, according to a Dow Jones Newswires survey. That was up 4.3% from a year ago, the highest calendar-year increase since 1988.

On Wednesday, the Labor Department reported a large drop in import prices for December. Consumer prices set for release Friday are also expected to show a steep decline, of 0.8% on a monthly basis.

If so, that may bring the year-over-year CPI rate down below zero for the first time since the 1950s, marking a sharp retreat from just a few months ago when inflation was considered a major threat.

Normally, signs of disinflation would be a welcome reprieve for households that saw their purchasing power eroded last year by soaring energy and food prices. But in the current climate, the latest price figures reflect the hard economic times that are causing consumers and businesses to delay many purchases, threatening a downward spiral of lower prices and declining spending and investment known as deflation.

However, the fact that core prices are still advancing should ease fears somewhat that deflation might grip the overall U.S. economy the way it did Japan’s in the 1990s.

According to Thursday’s report, energy prices posted a 9.3% drop last month, led by a record 25.7% plunge in wholesale gasoline prices. Food prices, meanwhile, were down 1.5%, the steepest drop in almost three years. Consumer goods prices, excluding food, were down 3% compared to November, reflecting the recent pullback in consumer spending.

Prices of passenger cars rose 1.2% on the month, partially reversing recent declines, while light truck prices advanced 0.8%.

Deeper in the production pipeline, prices fell sharply, suggesting more soft wholesale-price readings in coming months. Prices of raw materials, known as crude goods, fell 5.3% on the month, while core crude goods prices tumbled 2.2%.

Intermediate goods prices slid 4.2%. Core intermediate goods decreased a record 3% on the month.

By Brian Blackstone
Of DOW JONES NEWSWIRES

NEW YORK — In a speech that laid out a gloomy economic outlook, a Federal Reserve official also worried about managing the rapid rise in the central bank’s balance sheet.

“I don’t expect to see a turnaround until the second half of the year,” Federal Reserve Bank of Philadelphia President Charles Plosser said Wednesday. He expects the last quarter of 2008 to book a relatively sharp decline and said total growth for the current year “is likely to be well below 2%, after negative growth in 2008.”

The official said the current recession is likely to be the longest since World War II, although the current downturn in unlikely to replicate the sort of job losses seen in the past. “I do not expect the unemployment rate to stray into double digits during this recession,” even as any sort of moderation on that front is unlikely to arrive any time soon.

Plosser also said “the housing sector will finally hit bottom in 2009 and the financial markets will gradually return to some semblance of normalcy.”

He also said overall inflation measures, and those stripped of food and energy components, have moderated, as have expectations for future prices.

“My own projection is for inflation — both headline and core — to be below 2% for the next year,” Plosser said.

On the other side, “I am not particularly concerned about the possibility of persistent deflation” because as the impact of lower energy and commodity prices wanes, the downward pressure on prices will moderate, Plosser said.

The official spoke in comments prepared for delivery before the 2009 Economic Panel Outlook, held at the University of Delaware, in Newark, Del.

Plosser will end his voting status on the interest-rate setting Federal Open Market Committee when that body holds its first meeting of the year, at the end of this month. In December, the FOMC took unprecedented action and lowered its overnight target rate to a band of between zero% and 0.25%, as it seeks to aid a badly wounded economy.

Rock bottom interest rates have increasingly been joined by aggressive Fed efforts to provide liquidity and support key financial sectors, and it’s those efforts that have moved to the forefront of Fed policy.

Plosser’s comments come in the wake of several other Fed officials’ remarks, which have all agreed the economy will face a tough start to the year, with the hope that some sort of recovery will arrive later in the year.

Much of the central banker’s remarks centered on issues surrounding the rise of the Fed’s balance sheet, which has grown from just over $800 billion at the start of the current crisis, to $2.2 trillion. But he did reiterate that the Fed’s chief mission is keeping inflation under control, and that means officials must keep price pressures from being too high, or from falling outright.

The expansion of the balance sheet, while not unwarranted given the nature of the economy’s troubles, could create problems for the Fed later, especially as it seeks to control inflation, Plosser said.

“Our aggressive lending, while intended to help the economy and financial markets recover, poses its own set of challenges,” he said. “We must develop a well-articulated exit strategy if we are to maintain control of monetary policy and encourage the revival of strong and disciplined credit markets,” Plosser said.

The official expects to see the balance sheet grow further, but he also said “we must proceed with caution.” He explained, “we need to monitor that liquidity and its composition closely so that we are able to withdraw it when the time comes or else we risk fueling inflation in the future.”

Plosser, who has long argued in favor of an inflation target for monetary policy — the Fed does not have an official goal — thinks a similar sort of rigor could also be applied to the balance sheet, saying “it is not appropriate to ignore quantitative metrics in this new policy environment.”

By Michael S. Derby
Of DOW JONES NEWSWIRES

President-elect Barack Obama and congressional leaders plan to move soon to block the estate tax from disappearing in 2010, suggesting the levy might outlive the “Death Tax Repeal” movement that has tried mightily to kill it.

The Democratic stance on the estate tax contrasts with Mr. Obama’s reluctance to press forward with his campaign pledge to raise income-tax rates on top earners, which he worries could have an adverse economic impact during a recession.

But Democrats are determined to act quickly to prevent the estate tax’s scheduled repeal. Elimination of the levy on big inheritances was approved by Congress under President George W. Bush in 2001, with rollbacks phased in slowly and its full elimination slated to take effect next year.

The Senate Finance Committee will move within weeks on legislation to reverse that law, and Mr. Obama is expected to detail his estate-tax preservation proposal in his budget next month, congressional tax writers said.

Under the Obama plan detailed during the campaign, the estate tax would be locked in permanently at the rate and exemption levels that took effect this year. That would exempt estates of $3.5 million — $7 million for couples — from any taxation. The value of estates above that would be taxed at 45%. If the tax were returned to Clinton-era levels, it would exclude $1 million from taxation with the rest taxed at 55%.

In making their case for the restoration, Democrats contend that such a large additional tax break for the rich shouldn’t go into force halfway through Mr. Obama’s proposed economic-recovery package. They argue that the deficit is already in record territory, while their plan wouldn’t have any impact on the economy since it would merely keep the estate-tax rate at its current level. Mr. Obama and his party also say that the affluent already have benefited handsomely from the Bush tax cuts.

They also reason that if they don’t act now, it will be politically harder to go ahead with their plan to resurrect the estate tax once it has disappeared.

For small-business groups, farmers” associations and the affluent families that created and bankrolled the “Death Tax” repeal effort, the emerging Democratic plan marks a stark defeat.

Advocates of killing off the tax say the emerging Obama policy is the wrong medicine for the recession, arguing the levy is economically burdensome like the income tax. Bill Rys, tax counsel for the National Federation of Independent Business, said small businesses struggling with falling sales and layoffs shouldn’t have to devote resources to estate planning.

“With auto sales at a 16-year low, dealerships are already struggling. Freezing the 2009 levels would put an even greater burden on the future,” said Bailey Wood, chief lobbyist for the National Automobile Dealers Association.

At the level proposed in the Obama policy, all but the largest estates — fewer than 2% of annual deaths — would escape taxation. Over 10 years, the Obama plan would cost the Treasury around $324 billion more than if the Clinton estate-tax levels were maintained, according to the Joint Committee on Taxation. Full repeal would cost more than $500 billion over a decade.

The estate tax was enacted in the early 20th century as a levy on wealth and inherited assets. It was later amended to allow a spouse to avoid the tax.

Most such taxes are still collected from estates of the ultra-rich. But business and farm groups say small businesses and family farms struggle with it as well, at the very least devoting time and energy to planning ways to escape or minimize taxation as enterprises pass from generation to generation.

Patricia Soldano, an estate-tax planner in Southern California, was a pioneer of the movement launched in the mid-1980s. Backed by affluent families such as the Mars candy family, the Gallo wine family and the heirs of the Campbell’s soup fortune, Ms. Soldano enlisted Republican pollster Frank Luntz to poll-test the “Death Tax” term, forged alliances with the young Republicans who would sweep to power in 1994 and teamed up with small-business and farm groups.

By framing it as a tax on dying rather than wealth and thrusting family farms and small businesses front and center, the movement was able to divorce the cause from the issue of dynastic wealth and broaden its appeal to Main Street advocates.

The campaign seemed to have succeeded in 2001 when, with huge projected budget surpluses, Mr. Bush pushed and Congress approved an estate-tax repeal.

But to win the necessary votes for the larger, $1.35 trillion tax cut of which it was part, Republican leaders used legislative tactics that mandated the entire tax package expire in a decade. To lower the 10-year cost, the estate tax didn’t begin dropping significantly until the end of the window and wouldn’t disappear until 2010.

During the long phase-in, the politics have begun to shift again. Almost since the change was put in place, repeal advocates have pushed for an earlier permanent elimination in the face of huge budget deficits, with no luck. They always sensed an estate-tax elimination set far in the future was tenuous at best, especially since the law as written has the repeal last only one year.

Then, anticipating Democratic majorities in Congress that would ultimately seek to block full repeal, the coalition began seeking compromises that would leave a minimal tax in place for a tiny fraction of estates. Estate-tax opponents agreed they would get the best possible deal with Mr. Bush still in office.

But sharp divisions in the coalition emerged between the super rich and the merely rich. Business groups have sought a measure of certainty with an estate tax that is free of graduated timelines or sunset provisions, with the largest possible tax exemption — $10 million, or $20 million per couple. The rate of taxation above that level was of little concern, since virtually every small business would be exempt from taxation.

Yet the super affluent who began the movement wanted the lowest possible rate, since even a $10 million exemption would leave the bulk of their estates subject to tax. They backed a call by Mark Bloomfield of the American Council for Capital Formation to tax all estate transfers as capital gains, at 15%, with little or no exemption.

“The very wealthy, in their quest to reduce their exposure, made proposals that threw the small-business community overboard,” said one prominent small-business lobbyist, referring to a move to have estates taxed as capital gains upon their disposition, without regard to the amount shielded from taxation.

Ms. Soldano said “the small-business people were being shortsighted in thinking, ‘Let’s just fix it now for me.’”

Former Sen. Don Nickles, an Oklahoma Republican who fought the tax his entire political career, said he and Arizona Republican Sen. Jon Kyl must have given 10 speeches to the movement, exhorting them to come together and accept the best that could pass Congress while the GOP had control.

Now, the movement is likely to confront an estate tax that is far bigger than what it may have gotten with more compromise.

“People mistook political reality,” Mr. Bloomfield said. “The end result is we’ll have a worse tax policy than if Sen. Kyl had succeeded.”

Senate Finance Committee Chairman Max Baucus said in a recent interview that he will move “in the next few weeks” on legislation to deal with urgent tax matters not related to any economic stimulus. Estate-tax preservation will be front and center, an aide to the Montana Democrat said.

But movement veterans are already conceding defeat is likely. “I am disappointed,” Ms. Soldano said, “because I really thought we could achieve so much more.”

By Jonathan Weisman
THE WALL STREET JOURNAL

WASHINGTON — The final employment report for 2008 closed the books on a miserable year for U.S. workers with payrolls plunging last month by more than half a million, pushing the unemployment rate to a 16-year high of more than 7%.

The economy lost 2.6 million jobs last year, the most since Harry Truman was president in 1945, though the labor force was much smaller then. Nearly 2 million of those losses were in the last four months of 2008 alone, a sign that the recession accelerated as the financial crisis intensified and should drag on well into the new year.

The figures will likely put pressure on Federal Reserve officials to expand already aggressive quantitative easing steps in which cash is essentially created and pumped into the economy, and gives backing to those calling for large-scale fiscal stimulus.

Nonfarm payrolls, which are calculated by a survey of establishments, tumbled 524,000 in December, the U.S. Labor Department said Friday, the 12th-straight decline and in line with the 525,000 drop Wall Street economists in a Dow Jones Newswires survey expected. November was revised to show an even steeper decline of 584,000, the most since 1974, and October was also worse than first thought.

The pullback was broad-based among manufacturing, construction and most service industries. Companies across a variety of sectors, including AT&T Inc. (T), DuPont Co. (DD) and Bank of America Corp. (BAC), all announced job cuts last month. That trend continued into this year with Alcoa Inc. (AA), EMC Corp. (EMC), Walgreen Co. (WAG) among others announcing cuts in January.

Meanwhile, the unemployment rate, which is calculated using a separate survey of households, jumped 0.4 percentage point to 7.2%, the highest since January 1993. Economists think the jobless rate, which was just 5% as recently as April, will hit 8% or higher in coming months.

“At this pace, the unemployment rate could well test double digits later this year, and certainly looks well on course to do so during 2010 at the latest,” said ING Bank economist Rob Carnell, in a research note.

Indeed, according to the minutes of the Fed’s December meeting released Tuesday, its staff economists expect the unemployment rate to rise “significantly” into 2010.

By some broader measures, labor-market conditions are even worse than the main numbers suggest. When marginally attached and involuntary part-time workers are included, the rate of unemployed or underemployed workers reached 13.5% last month, up almost six percentage points from a year earlier.

With the Fed having already lowered official interest rates to near zero last month, officials will have to rely on quantitative easing through the Fed’s balance sheet to pump money into the financial system, and officials will likely face more pressure to widen their efforts.

Average hourly earnings increased $0.05, or 0.3%, to $18.36. That was up just 3.7% from a year earlier, suggesting wage inflation remains under wraps.

Friday’s numbers, along with weak automobile and retailer sales reports for December, suggest that after contracting just 0.5% at an annual rate in the third quarter, gross domestic product probably plunged 5% or more in the fourth quarter, which would be the steepest decline since the early 1980s.

Many economists expect U.S. GDP to contract again this quarter, albeit at a softer pace, and stall or contract next quarter as well.

Against that backdrop, expect another 1.5 million job losses at least by the middle of the year, said Harm Bandholz, economist at UniCredit Markets and Investment Banking.

According to Friday’s report, employment last month in goods-producing industries plunged by just over 250,000. Within this group, manufacturing firms cut 149,000 jobs, with motor vehicles and auto parts makers accounting for 21,000 job losses.

Construction employment was down by 101,000 last month and has fallen almost 900,000 since peaking in September 2006.

Service-sector employment tumbled 273,000. Labor-intensive services make up the vast majority of employment and usually cushion downturns. Yet business and professional services companies shed 113,000 jobs, the second-straight six-figure loss, and financial-sector payrolls were down 14,000.

Retail trade cut over 66,000 jobs, reflecting the bleak holiday shopping season. Leisure and hospitality businesses, meanwhile, shed 22,000 jobs as households rein in non-essential spending.

Temporary employment, which economists consider a leading indicator of future job prospects, fell by more than 80,000.

Among the sole bright spots were health care and education, which tend to be more labor intensive and less productive than manufacturing and other services. Employment in those sectors together rose 45,000.

The government added 7,000 jobs.

The average workweek fell 0.2 hour to 33.3 hours. A separate index of aggregate weekly hours fell 1.2 points to 103.5.

In another worrying sign, business wholesale inventories decreased in November by 0.6% compared with the prior month, the Commerce Department said, as sales plunged a record 7.1%. Automotive inventories increased 1.2% as sales fell 10.6%, suggesting that people afraid for their jobs aren’t making big purchases.

According to Insight Economics analyst Steven Wood, inventories should depress GDP in both the fourth quarter and first quarter.

By Brian Blackstone
Of DOW JONES NEWSWIRES

NEW YORK — The affluent and those of modest income alike stand to gain from an Internal Revenue Service pledge to go easier on taxpayers who can’t pay what they owe during the current tough economy.

Details of an IRS plan to soften its approach remain sketchy, however. Tax advisers who work on collections issues say they have doubts about if and how it will really work.

IRS Commissioner Doug Shulman said this week the agency is taking five steps to help financially distressed taxpayers. They include letting some who face difficulties defer taxes.

“Each one of these sounds great, but I’m just asking for the details,” said Robert E. McKenzie, a partner in the Chicago law firm Arnstein & Lehr LLP and the author of several books on the IRS and U.S. Tax Court. The IRS recently named him to its Advisory Council.

Low- and moderate-income taxpayers have long faced draconian IRS collection policies that needed reforming, according to McKenzie. Wealthy clients who have lost a fortune in the stock market will need new flexibility the IRS plans to offer, according to tax advisers.

Nonetheless, no taxpayer should take anything for granted as the agency attempts to take a softer line on collecting from those facing a job loss or other difficulties such as steep, unexpected medical costs. The IRS has historically taken a hard line in collecting, according to accountants and tax attorneys.

“I’d say it’s a dramatic departure from the current policies of the IRS, and one would hope they succeed in moving in a more reasonable direction,” said William E. Halmkin, a tax and litigation partner in the Boston office of law firm Sullivan & Worcester and formerly the deputy commissioner of the Massachusetts Department of Revenue.

Halmkin said he is hopeful the IRS will be able to enforce the new approach.

IRS Plan Has Several Parts

Shulman said he has given tax assisters greater authority to suspend collection actions for taxpayers facing a job loss, unexpected medical bills or other difficulties.

Tax debt won’t be forgiven in these cases, but the IRS will defer collection activity, including notices and phone calls, levies, seizures and penalties, IRS officials said.

Secondly, taxpayers who miss a payment under an installment agreement with the IRS won’t automatically have their agreement suspended.

The IRS will also broaden eligibility for its “offer in compromise” program by considering some taxpayers who appear to have enough equity in their home to cover their tax debt. Under an offer in compromise, a taxpayer can settle with the IRS for less than the full amount of taxes owed.

In the past, offers in compromise have not been considered from such taxpayers.

Robert Willens, a tax analyst at Robert Willens LLC, said he thinks the IRS initiative may embolden advisers to seek more offers in compromise.

Shulman said he has established a special unit to review specific cases where taxpayers with equity in real property may be eligible for an offer in compromise.

Also, taxpayers who miss a payment under an existing offer-in-compromise agreement can work with IRS officials to avoid defaulting on that agreement.

Finally, Shulman said the IRS will speed levy releases for taxpayers in financial hardship. This should make it easier for those behind on their taxes to stop the IRS from garnishing their wages, a practice that can be devastating for struggling families, according to McKenzie.

Taxpayers who are having difficulty meeting their obligations should contact the IRS to take advantage of the new flexibility, Shulman said.

Tax advisers say it’s crucial to reach a real person rather than relying on automated systems that are used to handle some collections.

The key is to stay in contact with the IRS, not “put your head in the sand,” said Claudia Hill, who owns the tax services company Tax Mam, Inc. in Cupertino, Calif.

Upscale taxpayers who have lost their jobs or seen businesses go under are still going to have a hard time convincing the IRS to be flexible in collecting taxes, according to Hill.

The IRS “can tell you that if they owe more $25,000, they are still going to have to jump through hoops and will still be working with people who don’t understand,” said Hill.

By Arden Dale
A DOW JONES NEWSWIRES COLUMN