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US Stocks Just Suffered Their Biggest 1-Day Decline Since June 2020. Here's Why an Inflation Surprise Tanked the Market. Stubborn inflation may spur the Fed to keep hiking interest rates, potentially triggering a recession.

By Theron Mohamed

This story originally appeared on Business Insider

REUTERS/Lucas Jackson via Business Insider
REUTERS/Lucas Jackson via Business Insider
  • US stocks on Tuesday registered their steepest one-day decline since June 2020.
  • Investors dumped stocks and other assets after learning month-on-month inflation rose in August.
  • Stubborn inflation may spur the Fed to keep hiking interest rates, potentially triggering a recession.

The US stock market suffered its worst one-day decline since June 2020 on Tuesday, as stubborn inflation crushed investors' hopes of an early end to the Federal Reserve's campaign of interest-rate hikes, and stoked fears of a painful recession.

The Dow Jones Industrial Average slumped 3.9%, the S&P 500 slid 4.3%, and the Nasdaq Composite tumbled 5.2%. Investors also sold bonds, oil, gold, and cryptocurrencies in response to a bleaker economic outlook.

The frantic selloff was sparked by the release of US inflation data on Tuesday, which showed that in August, the Consumer Price Index rose by 0.1% month-on-month, compared with expectations for a 0.1% drop. In contrast, year-on-year inflation came in at 8.3%, down from 8.5% in July and from the 40-year high of 9.1% it reached in June.

Faster month-on-month inflation signaled to investors that the Fed was unlikely to curtail its rate hikes anytime soon. It also fanned concerns that the central bank would approve a bumper rate increase of 0.75 basis points or even 100 basis points at its September meeting, and interest rates might peak at a higher level than previously expected.

Why an inflation surprise tanked the stock market

Rising interest rates are anathema to much of Wall Street, as they weigh on financial markets and the economy.

"Interest rates are to asset prices like gravity is to the apple," Warren Buffett said in 2013. "They power everything in the economic universe."

The famed investor was emphasizing that raising interest rates translates into bigger, virtually guaranteed returns from Treasury bonds and savings accounts. As a result, stocks and other assets become relatively less appealing, and have to generate higher and higher returns to justify the risk that investors take by owning them.

Rising rates also spell trouble for indebted companies, as the cost of servicing loans increases, and it becomes tougher and pricier to raise new capital.

On a macroeconomic level, raising interest rates encourages saving and makes borrowing more expensive, which typically weighs on consumer spending, investment, and exports. The result is often slower economic growth, higher unemployment, and slower inflation as demand for goods, services, and workers declines.

However, the current bout of inflation may be resisting rate hikes because it's a product of not only strong demand, but limited supply. Near-zero interest rates, stimulus checks, and federal aid for businesses shored up markets and the economy during the pandemic, likely contributing to price increases.

However, Russia's invasion of Ukraine has also caused a surge in food and energy prices, while continued COVID-19 lockdowns in China have disrupted global supply chains and exacerbating shortages.

Those myriad factors could mean the Fed struggles to slow inflation to its target level of 2% a year. If the central bank keeps hiking rates to no avail, it risks plunging the economy into a recession or even a stagflationary crisis, characterized by slowing growth, high inflation, and rising unemployment.

In short, investors dumped stocks and other assets on Tuesday because higher monthly inflation fanned their fears of a nightmare scenario, where aggressive rate hikes fail to slow price increases, plunging markets and the economy into painful, protracted downturns.

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