The Dow falls 880 points as inflation hits 40-year high

By Nicole Goodkind, CNN Business

    (CNN) -- It's been yet another week of losses for US markets after steep drops on Friday.

The Dow plunged after a key inflation report missed estimates and showed a higher-than-anticipated increase in the price of consumer goods, closing down 880 points for the day, or 2.5%. The S&P 500 shed 2.7% and the Nasdaq dropped about 3%.

The May consumer price index rose 8.6% year-over-year, its highest level since 1981. Economists had forecast an 8.3% increase. The core index, which excludes food and energy prices, rose by 6%, slightly higher than estimates of 5.9%.

Those numbers sent investors reeling. Already worried about a possible economic downturn, they now fear that the Federal Reserve will recognize inflation as entrenched in the economy and increase interest rates further.

The central bank is expected to announce a half-percent interest rate hike next week, but based on this news it could decide to go higher.

"We think the US central bank now has good reason to surprise markets by hiking more aggressively than expected in June," wrote Barclays analysts in a research note on Friday. "We realize it is a close call and that it could play out in either June or July. But we are changing our forecast to call for a 75 [basis point] hike on June 15."

The move would be historic -- the last time the Fed delivered a 75 basis point hike was in November of 1994, nearly three decades ago.

Analysts appeared to be unhappily pricing in the potential for the interest rate hike on Friday. And while many analysts feared that the Federal Reserve was doing too little too late to curb rising inflation rates, they also worrythat sudden large increases in interest rates will do damage to the economy.

"The major risk to consumption, employment, and the economy overall, isn't an organic growth slowdown, but the extent to which extreme energy and food price increases could cause central banks to push against the string, and [the economy could] essentially fall into a damaging policy mistake," wrote Rick Rieder, chief investment officer of Global Fixed Income at BlackRock in a note.

The sell-off on Friday was broad in scope, with stocks in the red on the New York Stock Exchange outnumbering stocks that increased by about nine to one.

The White House conceded that Friday's inflation number was "uncomfortably high," further stoking investor fears of policy action.

Federal Reserve policymakers have historically focused on Personal Consumption Expenditures and not CPI as their preferred inflation measure. But core PCE also increased 0.34% in April, bringing the year-over-year figure for the measure to 4.9%. That number was down a bit from 5.2% in March but it is still elevated.

"The probability of a recession in the next year or so is rising," said Sung Won Sohn. professor of finance and ecoomics at Loyola Marymount University and chief economist of SS Economics. "Inflation is eating away at consumers' purchasing power."

Consumer spending accounts for about 70% of the US economy, and a real decrease in that spending would be a huge blow to gross domestic product. "The [Federal Reserve] now recognizes that it is way behind the curve on inflation and must act more decisively," said Sohn.

The Dow had its 10th down week in 11 and the S&P 500 and Nasdaq its ninth losing week in the past 10. The S&P 500 is now down about 19% from its record high in January and is once again approaching bear territory.

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