Why did the stock market go down today? Thank May's inflation report

Elisabeth Buchwald and The Associated Press
USA TODAY and The Associated Press

Turns out inflation hasn't peaked.

Last month, the Consumer Price Index hit a new 40-year high after easing off a bit in April. Stocks haven't been taking the news well.

The Dow Jones Industrial Average closed down by 881 points, or 2.73%. The S&P 500 closed down nearly 117 points, or 2.91%. And the Nasdaq Composite was closed down 414 points, or 3.52%.

Friday's close puts the S&P 500 just 1.49 percentage points away from hitting the bear market threshold, equivalent to a 20% since its record high in January. As of Friday, it was down 18.5% from January. 

Are investors overreacting to the inflation report or does Friday's selloff signify more danger ahead for the stock market?

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Why are stocks falling?

Stock prices rise and fall on two things, essentially: how much cash a company produces and how much an investor is willing to pay for it. The Fed's moves on interest rates heavily influence that second part.

Since early in the pandemic, record-low interest rates engineered by the Fed and other central banks helped keep investment prices high. Now “easy mode” for investors is abruptly and forcefully getting switched off.

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Inflation rose 1% last month, hitting a new 40-year high.

Not only that, too-aggressive rate hikes by the Fed could ultimately force the economy into a recession. Higher interest rates make borrowing more expensive, which drags on spending and investments by households and companies.

Will CPI inflation report prompt the Fed to raise rates?

The Federal Reserve has already begun raising interest rates and making other moves in order to slow the economy, in hopes of forcing down inflation. Wall Street took Friday’s reading to mean the Fed’s foot will remain firmly on the brakes for the economy, dashing hopes that it may ease up later this year.

"The question is whether the unexpected strength of the May inflation numbers are enough to push the Fed to move more aggressively next week or in July," Jim Baird, chief investment officer at Plante Moran Financial Advisors, said in a note.

"Given their cautious approach to this point, it seems unlikely, but Fed policymakers have to be careful to do whatever is needed to avoid further damage to their credibility," he added.

The growing expectation is for the Fed to raise its key short-term interest rate by half a percentage point at each of its next three meetings, beginning next week. That third one in September had been up for debate among investors in recent weeks. Only once since 2000 has the Fed raised rates by that much, last month.