An unsettling inflation report sent financial markets into a tailspin Friday, with bank stocks taking one of the biggest hits.
Stock prices sank in sympathy with bonds. The Dow Jones industrial average plunged 33.65 points to close at 3874.81
The unexpectedly big jump in producer prices in August prompted speculation that the Federal Reserve will be forced to raise short-term interest rates again soon.
Investors dumped bank stocks in the apparent belief that a rising interest rate environment is bad for banks, but the selloff was denounced as a "mindless gut reaction" by bank stock analyst Stephen Berman at Natwest Securities in New York. He argues that rising interest rates actually can be good for banking fundamentals.
Bond prices immediately plunged on the release Friday morning of the Labor Department's August index of producer prices. which rose 0.6%, well above the conseasus forecast of 0.4%. The next reading on inflation will come Tuesday, with the release of the consumer price index.
"Clearly, this is not a good report on inflation," said Sung Won Sohn, chief economist at Norwest Corp. in Minneapolis, of the producer price increase. But he does not believe that a further credit tightening by the Fed is a foregone conclusion.
The central bank has already raised short-term interest rates five times this year, most recently in August, when it boosted both the federal funds and discount rates by half a percentage point.
Banks immediately followed the Fed move with a half-point increase in the prime rate, which now stands at 7.75%, or three percentage points above the fed funds target rate of 4.75%.
Mr. Sohn said banks will remain in lockstep with the fed to maintain that spread.
But he does not expect any further rate increase by the central bank until after the fall elections, if at all.
Mr. Sohn said the August PPI report "validates" what the Fed has done already on the inflation-fighting front, but does not necessarily provide justification for further credit tightenings.
"It all depends on the economic numbers that come out between now and mid-November," he said.
"We've yet to see the impact of the Fed's latest moves." said Keith Lawder. a senior vice president and group executive for business banking at Wachovia Bank of Georgia
So far, rising interest rates haven't dampened borrowing activity among Mr. Lawder's small-business customers. Many of his customers have annual sales of $10 million or less, and their borrowing rates are tied to the prime rate.
In the face of rising credit demand, the banking industry's determination to maintain margins means earnings are going to hold up pretty well, said Mr. Sohn at Norwest.
Natwest's Mr. Berman also points out that while the prime rate has been rising at a steady clip this year, banks have been much slower to boost deposit rates.
"I think by the fourth quarter, you will see many banks with flat to rising net interest margins" as a result of the higher prime rate and lagging deposit rates, he added.
