Despite a deep slump in housing and turmoil in the credit markets, job growth has been largely steady, if modest.

No more.

The report on December employment showed that American employers are furiously retrenching, fearful of hiring amid a slowing economy and rising costs.

Employers created only 18,000 jobs last month, roughly a third of the median forecasts. It was the weakest month in job creation since August 2003, when the economy lost 42,000 jobs. Job growth was revised up by a total of just 10,000 in October and November.

"The U.S. December employment report today, together with elevated figures for initial and continued claims for unemployment benefits in the last few weeks, confirms that the last factor that was supporting the economy and a shopped-out consumer—income and labor generation—is now faltering, making a recession effectively unavoidable," says Nouriel Roubini on his blog.

The gloomy data sparked a wave of selling in stocks.  The Dow Jones industrial average tumbled 256.54 points, or nearly 2 percent. The technology-heavy Nasdaq composite index slid 3.8 percent. The Standard & Poor's 500-stock index fell 2.5 percent. It was the market's worst week since last summer. Treasury prices surged, sending yields sharply lower.

Steep losses in construction and manufacturing jobs offset gains in several service industries, including professional and technical services, health care, and food services, the Labor Department said. Indeed, private employers overall cut 13,000 jobs last month; local, state, and federal governments added 31,000 jobs.

The unemployment rate, which was at 4.5 percent a year ago, is now 5 percent, up from 4.7 percent in November. Average hourly earnings rose by 7 cents, or 0.4 percent.

The weakness in the data presents a huge challenge to the Federal Reserve, which is trying to bolster growth while attempting to keep inflation at bay. The December report would appear to make another rate cut of at least a quarter point at the end of the month all but certain.

After the report, the February federal-funds futures contract showed a 73 percent chance that the Fed would cut its benchmark rate by a half point, to 3.75 percent. 

Rick Meckler, president of Libertyview Capital Management in Jersey City, New Jersey, told Reuters that the Fed will now be forced to cut rates despite its worries that inflation is increasing.

"The risk to the Fed has always been between growth and inflation, and this seems to tip the scale toward sustaining growth and worrying about inflation another day," he said. "It makes rate cuts not only likely, but extends them."