Deflation worries send Dow below 8,000

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A record 1 percent drop in consumer prices last month — the biggest in at least 61 years — raised worries Wednesday on Wall Street that the economy may be engulfed in a destructive bout of deflation, sending the Dow below 8,000 for the first time in five years.

The Dow Jones Industrial Average fell 427 points or 5 percent to 7,997, while the Standard & Poor’s 500 index and Nasdaq Composite Index both lost more than 6 percent and ended at lows last seen in 2003. Worries about bankruptcy among Detroit’s automakers, as well as an all-time low in housing construction hit last month, contributed to fear that the economy’s steep fall will only continue in the months ahead.

“The economy’s really just in horrific shape,” said Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities.

“The theme now seems to be one of deflation,” said Tom di Galoma, head of U.S. Treasury trading at Jefferies & Co. “That’s the fear at this point.”

Deflation means that prices overall are dropping, rather than rising — something that last occurred in the United States during the Great Depression in the 1930s and in Japan during the 1990s. As prices dropped, consumers postponed spending as they waited for prices to fall further, causing economic growth to grind to a halt. Meanwhile, businesses had trouble recouping their costs, debtors had trouble paying their bills, and the banking system was undermined by rising defaults.

That specter haunted the markets Wednesday. But while prices fell last month in a way never seen in modern times, a one-month drop is not deflation. Overall inflation still is up by 3.7 percent over last year, according to the Labor Department’s Consumer Price Index released Wednesday. Economists say deflation is only a threat if the recent trend in prices continues well into next year.

Federal Reserve Vice Chairman Donald Kohn called the risk of deflation “small” in remarks before the Cato Institute on Wednesday. But he added that the Fed should take “a lesson” from Japan in the 1990s and be “aggressive” about not allowing deflation to “get ahead of us.” His remarks bolstered expectations that the Fed will slash interest rates again next month to counteract deflation and weakness in the economy.

So far, the big drop in inflation from levels that peaked at around 6 percent this summer has been welcome news for consumers, who only a few months ago listed high gasoline prices as their No. 1 economic concern. But it also is symptomatic of an economy in deep trouble. Recent reports have shown a virtual free-fall in housing, auto sales and other important sectors.

The biggest factor feeding the abrupt drop in inflation so far has been a precipitous decline in the price of oil and other commodities prices since July as a recession that probably began in the United States at the beginning of the year spread to the rest of the world this summer. The sudden economic downturn in once-booming economies from China to Brazil brought an abrupt end to a bubble in oil prices.

Hedge funds and other speculators had driven a steep run-up in oil prices during the first half of the year to a record high above $147 a barrel. That fed the spike in inflation, but the rapid retracing of those gains is now quickly dousing the inflation fires.

Oil prices have collapsed to $53.08 in New York trading Wednesday, while gasoline prices staged an unprecedented retreat from more than $4 a gallon in July to less than $2 in many parts of the country today. The inflation report showed that energy prices overall have plummeted at a 43 percent rate in the three months since July, lowering transportation costs for Americans by 26 percent.

The astoundingly fast plunge in oil prices, which gathered speed this fall after the outbreak of the credit crisis, was probably a result of the chaotic unwinding of leveraged positions by hedge funds and other speculators, analysts say.

“The sudden slowdown in economic activity virtually everywhere in recent months drastically changed market expectations of commodity demand,” said Roger Kubarych, economist at Unicredit Markets. “As prices began to sink, deleveraging by hedge funds and proprietary trading desks magnified the selling pressures almost overnight.”

Since oil is used widely throughout the economy, the sharp decline in energy prices eases inflation pressures in many other areas.

New auto prices slid by 0.5 percent last month; used-car prices dropped by 2.4 percent; clothing prices plummeted by 1 percent; hotel rates sank by 1.6 percent; and airfares plunged by 4.8 percent.

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