Consumers Feeling Pinch as Inflation Rises; Stocks Fall on Interest Rate Fears

Financial markets took a sudden dive Wednesday on fears that rising inflation could push interest rates higher and threaten the economy.

The sell-off on Wall Street and around the world was triggered by a report showing a surprisingly large increase in U.S. consumer prices in April. That could force the Federal Reserve to prolong its nearly 2-year-old campaign of raising interest rates -- making mortgages, credit cards and other debt more costly.

Motorists already are familiar with soaring prices at the gasoline pumps. But the latest consumer inflation report suggested that higher energy costs, combined with a strong economy, were pushing up prices for a wide variety of goods and services, including rents.

Karen Davis-Weyman is feeling the squeeze. She and her sister moved into a new two-bedroom apartment at Sunset Boulevard and Vine Street in Hollywood last August, paying $2,500 a month. They recently received notice that their rent would go up by $350 a month when their lease comes up for renewal this summer.

“It’s really nice,” said Davis-Weyman, 22, “but it’s expensive.”

Inflation worries and the turmoil they are causing in financial markets are posing the first major test for new Federal Reserve Chairman Ben S. Bernanke, who succeeded Alan Greenspan in February.

The April inflation data released Wednesday sent some investors fleeing from stocks, driving the Dow Jones industrial average down 214.28 points, or 1.9%, to 11,205.61, its biggest one-day decline since March 2003.

Only a week ago the Dow was within 80 points of its all-time high reached in January 2000, while many broader stock indexes already were at record levels. The market had been pumped up this year in part on hopes that interest rates were peaking. But share prices began to falter late last week on doubts about rates.

The jump in inflation stunned investors because it appeared to contradict what Bernanke and other Fed officials have been saying for months -- that inflation expectations were “contained,” despite the surge in energy costs over the last year and the economy’s robust growth.

Investors now fear that “the economy is going to overheat, inflation is going up, and the Fed can’t pause” in raising rates, said Al Kugel, a strategist at Stein Roe Investment Counsel, a financial advisory firm in Chicago.

Higher interest rates are the central bank’s principal weapon against inflation. By tightening credit, the Fed aims to slow the economy and thus reduce demand for goods and services.

The overall consumer price index jumped 0.6% in April, and the so-called core index -- excluding food and energy costs -- was up 0.3%.

To be sure, the latest inflation numbers are a far cry from the double-digit annualized price increases of the late 1970s.

It’s the trend that is worrisome: The core index rose at a 3% annualized rate in the first four months of this year, compared with 2.2% for all of 2005.

This year’s increase is “well above what we’ve been used to and what the Fed would be comfortable with,” Kugel said.

Rising inflation is considered a scourge because it erodes the value of investments and consumers’ purchasing power, threatening an upward spiral of prices and wages.

“Clearly, [Wednesday’s] report calls out the Fed” to show its mettle, said John Brynjolfsson, who manages bond portfolios at Pacific Investment Management Co. in Newport Beach.

Greenspan, who chaired the Fed for 18 years, had an image of being tough on inflation. On his watch the consumer price index fell from 4.4% in 1987 to 1.9% in 2003. But that slide was helped by a crash in oil and other commodity prices in the 1990s, putting downward pressure on inflation overall.

Low inflation allowed the Fed to slash its key short-term rate to 1% by 2003 to help the economy revive from the 2001 recession.

In mid-2004 the Greenspan Fed began to raise rates, citing an improving economy.

When Greenspan left the chairmanship in January, handing the reins to Bernanke, the Fed’s rate was 4.5%. The Bernanke Fed has since raised the rate twice, to the current 5%.

In recent months, many economists said the Fed had done enough to restrain inflation, and could afford to go on hold at 5%. Bernanke reinforced that notion in testimony before Congress on April 27, when he said that, “At some point in the future, the [Fed] may decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook” for the economy and inflation.

With the April consumer prices report, Bernanke and his Fed peers now are in a difficult position, analysts said.

If financial markets fear that policymakers have let inflation get away from them, stocks could crumble and long-term interest rates, such as on Treasury bonds and mortgages, could surge. That, in turn, could slam consumer and business confidence and slow the economy dramatically.

The rate, or yield on the 10-year Treasury note, a benchmark for mortgages and other long-term rates, has moved up sharply in recent weeks, to 5.15% on Wednesday. It was at 4.4% at the start of the year.

At the same time, analysts note that Fed rate increases affect the economy with a lag -- which means that the bulk of the effect from rate hikes over the last year may hit in the second half of this year.

The U.S. housing market already is showing signs of slowing markedly, said Christopher Low, an economist at investment firm FTN Financial in New York.

“We have a significant housing correction underway, and now the risk is that the Fed raises rates another half-point or full point to win back their credibility” as inflation fighters, Low said.

“If they do much more than they’ve already done, recession is a serious risk,” he said.

Some analysts, however, believe that inflation risks merit higher interest rates, and that the economy could handle them.

But the Fed also faces other challenges to the inflation and interest-rate outlook. One is the weakening dollar, which has sunk against other major currencies this year. A falling dollar can boost prices of imported goods, worsening inflation concerns.

What’s more, the global economy is on a hot streak that is the strongest and broadest expansion since the early 1970s, according to the International Monetary Fund. That is pushing up interest rates in Europe, Canada and China, which in turn adds to pressure on U.S. rates.

For Bernanke, the market whiplash may stir up anxious memories of what Greenspan faced in his first few months in office in 1987: rising inflation worries amid surging bond yields and a falling dollar. That culminated in the stock market crash of October 1987, when the Dow sank 23% in one day.

Few analysts believe the stock market today is at risk of a crash. Many say markets were overdue for a pullback after rallying with few interruptions for the last three years. The Dow still is up 4.6% year to date.

But memories of 1987 put more pressure on the Fed to bolster investors’ confidence that inflation can be controlled.

“The Fed’s credibility is always on the line, but especially when you get a new guy in the hot seat,” said Kevin Caron, a market strategist at brokerage Ryan, Beck & Co. in Florham Park, N.J.

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Times staff writer Annette Haddad contributed to this report.