Stagflation Fears Sink Stocks

Major U.S. indexes tumbled Wednesday as crude oil topped $133 and the Federal Reserve lowered its outlook on U.S. growth

by Ben Steverman

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One day after the stock market slumped on inflation worries, a new batch of bad news fueled fears of stagflation and sent major U.S. equity indexes tumbling once again.

Stocks closed sharply lower on Wednesday, extending steep losses from the previous session, as jitters about soaring energy prices and their impact on the economy held sway over the market. Partly due to record fuel costs, American Airlines announced a sharp reduction in its flight schedule.

Minutes from the Federal Reserve’s April policy meeting showed the Fed is worried about inflation. The central bank also cut its outlook for U.S. economic growth.

Bonds fell along with stocks as investors braced for reports on weekly initial jobless claims and housing prices due Thursday. Gold futures rallied.

On Wednesday, the Dow Jones industrial average tumbled 227.49 points, or 1.77%, to 12,601.19. The broader S&P 500 index fell 22.69 points, or 1.61%, to 1,390.71. The tech-heavy Nasdaq composite index lost 43.99 points, or 1.77%, to 2,448.27.

Activity in the broader market was resoundingly negative, with 22 stocks declining in price for every 9 that gained on the New York Stock Exchange. The ratio on the Nasdaq was 20-9 negative.

Oil futures moved above $133 per barrel after Energy Dept. data showed U.S. crude oil inventories unexpectedly fell 5.4 million barrels, gasoline stocks fell 800,000 barrels and distillates rose 700,000 barrels. Analyst Tim Evans of Citi Futures said "higher

refinery crude runs and a sharp drop in imports led to the surprise draw in DOE crude stocks” and noted that inventories are now 6.9% lower than a year ago.

June crude oil futures settled up $4.19 per barrel at $133.17 on Wednesday, reports Action Economics, and moved higher still in after-hours trading, to a record $133.72.

Spiraling prices and slowing growth carry a familiar echo to economists. “What was still a threat six months ago has become reality in the U.S., and is likely to arrive in Europe soon -- stagflation, defined as a period of weak or no growth and unusually high inflation,” wrote Joachim Fels, chief global fixed income economist for Morgan Stanley, in a May 21 note.

Lawmakers concerned about higher oil prices grilled oil company executives in a Senate hearing on Wednesday and a House panel Thursday. Top executives at BP (BP), ConocoPhillips (COP), Exxon Mobil (XOM) and Chevron Corp. (CVX) testified.

"Record oil prices will hobble the U.S. economy," says Chris Lafakis of Moody's Economy.com. If prices stay at these levels, the extra demand during the summer driving season could push gas prices to $4.15 per gallon or even as much as an "unlikely but disconcerting" $4.75 per gallon, he said.

How long will oil's record run last? "A reasonable case can be made arguing that the market has become frothy and that the doubling in prices in little over a year will inevitably erode demand," says Action Economics. Action points to recent supply developments: Saudi Arabia has been pumping an extra 300,000 barrels per day (bpd) since May 10 and is planning to maintain production levels through the next month; Iraqi oil production is set to rise by at least 125,000 bpd in June; the U.S. government last week approved legislation to stop the refilling of the U.S. emergency stockpile until crude prices fell below $75 a barrel, a measure that will add around 75,000 barrels per day, according to Reuters.

But Lafakis says the problem is that demand is still strong, especially from emerging economies like China, while there is evidence supply is peaking form Norway, Mexico, Russia and other nations. Also, OPEC has given few signs it will pump more oil, he said.

AMR Corp. (AMR) announced a large reduction of American Airlines' flight schedule amid record fuel prices and a tough economy.