Inflation Fears Trigger Stock Sell-Off
May 17, 2006 — -- After several days of gradual declines, the Dow Jones industrial average plummeted more than 200 points today on inflation concerns after the Department of Labor released a report showing consumer prices climbed more than expected in April.
The stock slide began last week after the Federal Reserve raised interest rates. The Fed also spooked investors by releasing a post-meeting statement that indicated its 16th quarter-point interest rate hike might not be its last (a key federal interest rate stands at 5 percent).
Since then the Dow has plunged 437 points, and the Nasdaq has dropped more than 5 percent to a seven-month low.
"At a minimum, investors are sending a signal, and that is that they think the Federal Reserve is hitting the brakes and that they'll hit the brakes too many times. And, at a minimum, it'll slow the economy," said Hugh Johnson, chief investment officer at Johnson Illington Advisors.
This morning's surprisingly hot Consumer Price Index report sent the markets skittering lower, as traders sold on fears that the Fed would continue its quarter-point rate hike habit at the end of June. The report showed consumer prices for goods and services rising at an annual rate of 3.5 percent -- faster than the Fed likes to see.
Economists noted that the the "core" Consumer Price Index -- which measures prices without accounting for volatile food and energy prices -- was up 0.3 percent during April. That's more than expected and is likely in the Fed's red zone for inflation watch.
"When you take a close look at the numbers, you see that this is not just the price of gasoline going up at the pump," Johnson said.
Prices are also rising on many household budget items like clothing, child care, tuition and rent. The worry among traders and economists is that prices could continue going up.
"In that kind of scenario, the Fed would have to push interest rates much higher than anybody imagines right now, and that would be very bad for the stock market," said Wachovia economist Mark Vitner.
The Fed's mechanism for defusing inflation pressures is increasing interest rates. When rates are raised, consumers and businesses tend to buy less because it costs more to borrow money to fund things, whether it's to finance a major plant expansion or a pair of beach-friendly flip-flops.
With fewer buyers, prices don't go up as quickly.
The same is true for corporate profits. And when you buy stock, you're really buying the company's future profits. If the Fed governors succeed, corporate profits will see slower growth or, if they overshoot, profits could actually shrink. That's bad news for the value of stock.
To get out in front of those changes, investors sell.
The drop in the Dow Jones industrial average is the largest, in terms of points, since March 24, 2003, when the market fell 300.14 points. The Nasdaq fell by more points as recently as last Thursday. The S&P had a worse day in January 2006.
The sharp drops came after a period of increases that had brought the Dow close to a record high. Last Wednesday, before the Federal Reserve released its interest rate decision, the Dow was just 80 points from its all-time high of 11,722.98 (Jan. 14, 2000).
A look at how the markets closed:
- DOW 11,205.61 (-214.28 / -1.88%)
- NASDAQ 2,195.80 (- 33.33 / -1.50%)
- S&P 500 1,270.32 (-21.76 / -1.68%)
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