Inflation fears, a ballooning trade deficit and the continued slide of the dollar against the Japanese yen sent U.S. stocks yesterday to their biggest point drop since May.
The Dow Jones industrial average fell 225.43 points, or 2.08 percent, to close at 10,598.47 yesterday, while the technology-domi-nated Nasdaq composite fell 65.05 points, or 2.25 percent. The Dow had been down as much as 272.03, before ending the day with the largest drop since May 27.
Despite the sharp declines, analysts said the sell-off was a calm one, mostly growing out of the uncertainties raised by the economic news.
"There's no panic selling," said Barry Berman, head trader for Robert W. Baird & Co. in Milwaukee. "It has the feel of a market that was a little overextended, given the background of uncertainty."
Feeding investors' fears was a combination of bad news:
A July trade deficit of $25.2 billion that was a monthly record
The disclosure that the Bank of Japan refused to slow the dollar's decline against the yen.
A realization that a still-racing U.S. economy and the possibility of an uptick in inflation could prompt the Federal Reserve to raise interest rates a third time this year when it meets Oct. 5.
Higher interest rates could cause the economy to slow precipitously.
However, Wall Street's knee-jerk reaction to yesterday's news "was an overreaction," said Alfred Goldman, chief investment strategist for St. Louis-based A. G. Edwards.
"The economy is slowing, but it's slowing to a healthier rate of growth."
Yesterday's downturn underscored how capital markets have become increasingly global and how nearly all the economic activities fit together.
The trade deficit illustrated that consumers, at least as late as July, still were spending with a full head of steam. Economists had expected the trade deficit to fall from June to July -- instead, it set a record.
That has implications for interest rates, since too-buoyant spending can cause inflation, particularly when demand for goods is so strong that manufacturers have to hire more workers to increase supply.
Tight labor markets are inflationary, since workers' wages get bid up, and companies often pass the higher salary costs on to consumers.
That, in turn, could prompt the Fed to increase interest rates again next month to slow inflation and the consumer juggernaut.
Robert Parry, president of the San Francisco Fed, one of 12 district banks in the Federal Reserve system, said yesterday that the latest information on consumer spending "suggests there is not much slowing."
In the face of the Asian financial crisis, the Fed loosened credit in late 1998 by cutting interest rates three times. Magnifying the effect of those rate decreases was a so-called "flight to quality" by foreign investors, who pulled money out of their own, uncertain markets to buy more-dependable U.S. stocks and bonds.
That meant the U.S. economy was awash in cash, making it easier and cheaper for consumers to borrow for new cars or homes, or for companies -- especially Internet start-ups -- to obtain capital to invest in new plants, equipment or technology for expansion.
As foreign firms cut their product prices to stay afloat, the demand to invest money in the United States raised the value of the dollar against other currencies. The upshot: As prices of imports fell in real terms, the dollar's value rose against the home currencies of importers, meaning each dollar bought even more.
But now that the economies of Asia and Latin America are firming, all those factors are reversing themselves -- and working against U.S. consumers.
Prices for foreign imports are rising, just as the value of the dollar is slipping against the yen. Since each dollar now buys fewer yen, the dollar doesn't stretch as far, meaning that Americans will have to pay more just to buy as much -- which is inflationary.
Since the United States is a net-importer, higher consumer spending here translates into higher import levels.
That's inflationary in its own right, because higher spending creates big trade deficits, since foreign companies have to take some of the dollars collected from sales here and exchange them back into their home currencies -- in effect selling dollars and buying their own currencies.
That's partly what's happening in the foreign-exchange markets, where the yen is up 12 percent since June 10. The yen rose to 104.8 per dollar yesterday, an increase of about 1.3 percent from Monday.
Worse, from the viewpoint of investors, was yesterday's surprising revelation by the Bank of Japan that it would not intervene in world currency markets in an attempt to halt the yen's advance against the dollar.
Currency traders had been expecting the Bank of Japan to sell yen, which would cause that currency to fall -- in essence, making the dollar rise. Unless the bank changes its policy, it's possible the dollar's value could slide still further against the yen.
With U.S. inflation possibly returning, foreign investors might feel safer holding investments denominated in their home currency. The could begin dumping U.S. stocks and bonds -- in effect, selling dollars -- to reinvest that money back at home.
To counteract the weakening dollar, and the inflation it could spark, the Fed might have to raise interest rates, which would ultimately cause growth to slow here.
Many experts point out that the currency-trading markets are so large that even a concerted intervention by the Bank of Japan probably wouldn't have a lasting impact if the markets have determined that the dollar should slide in value.
But the July trade deficit "adds insult to injury" for the dollar, according to Mellon Bank currency strategist Marc Chandler; "the real focus is on the [Bank of Japan]."
The so-called "Goldilocks" economy of cheap goods and low interest rates that the United States has enjoyed the past couple of years may be at risk.
During the past few years, the United States did "a great public service and took in all the capital [ailing countries] wanted to ship us," said Neal Soss, chief economist for Credit Suisse First Boston Corp. in New York.
"With that, we bought imports, which revived the economies in that part of the world. [Now] we need to provide another public service: rein in spending so that some of that capital can stay at home" and allow the resurgence abroad to continue, said Soss.
Wire reports contributed to this article.
Pub Date: 9/22/99