Market swoons on deflation fears

A growing fear of economic deflation helped take the air out of the stock market yesterday, and another white-knuckle final hour on Wall Street pushed the Dow Jones industrials under 8,000 to their lowest close since the financial meltdown began and to levels not seen in five years.

Consumer prices in October took their biggest monthly plunge in the six decades that records have been kept -- a reprieve for shoppers but a danger sign for the economy, because falling prices can make a mild recession spiral into something worse.

The drop illustrated once again how quickly the economic danger can shift. The inflation fears that gripped the nation just a few months ago now seem like a distant memory.

"Consumer price inflation has suddenly screeched into reverse," said Brian Bethune, economist at IHS Global Insight. "The inflation threat has disappeared from the radar screen."

Another factor in the plunge is fear of a possible bankruptcy of General Motors, the nation's largest auto maker, said Kent Engelke, chief economic strategist for Capitol Securities Management in Richmond.

"If GM goes into bankruptcy, that will be a cataclysmic event for the economy and the credit markets," Engelke said.

Worried about the economic data, a gloomy outlook from the Federal Reserve and the fate of the Big Three automakers, investors yanked money out of the stock market. The Dow closed down 427 points, or about 5 percent, at 7,997 -- its lowest close since March 2003.

The S&P 500 Index fell 52.54 points, or 6.1 percent, to 806.58, a level last seen on March 12, 2003, when it closed at 804.19.

The technology-laden Nasdaq Composite Index dropped 96.85 points, or 6.5 percent, to 1,386.42, its lowest closing level in more than five years.

"I don't know what the catalyst is going to be where we turn the corner and people start buying stocks wholeheartedly again," said Jon Biele, head of capital markets at Cowen & Co.

The Federal Reserve sharply lowered its economic projections and signaled that further interest-rate cuts might be necessary to ease the economy's worst crisis since the Great Depression.

The consumer price index, the country's most closely watched inflation barometer, dropped 1 percent in October, the biggest monthly decline since the government started keeping records in 1947. Many analysts expect another drop for November.

That's a stunning reversal from as recently as June, when consumer prices increased 1.1 percent, the second-fastest pace in a quarter-century. Galloping prices for gasoline, food and other items were socking people's wallets and touched off widespread fears about inflation.

Even with October's price reprieve, Americans are in no mood for a shopping spree. They have cut back sharply on spending amid mounting strains from job losses, shrinking nest eggs and falling home prices.

The consumer pullback helped jolted the economy into reverse in the third quarter. More economic contraction in this quarter would meet the classic definition of a recession -- two straight quarters of negative growth.

Falling prices might not help, even on the shopping side.

"Consumers would wait to buy, because they would keep waiting for prices to go lower," said Rebecca Braeu, economist at John Hancock Financial Services. "That would curtail consumer spending."

"I am worried that the situation in the United States could turn into a deflationary period in this country if trends continue," said Sung Won Sohn, chief economist at the Martin Smith School of Business at California State University. "With economic conditions getting worse and not better, the risk of deflation is there."

With little hope that Congress will spring to the automakers' aid, Engelke said there are concerns that their debt could go into default, triggering huge losses on the credit default swaps insuring the debt.

"If you want to look at something that is positive, we are all going to be feeling a little bit better going to the gas pumps," he said. Gasoline prices that have dropped to $2.05 per gallon on average nationwide are providing consumers billions of dollars of potential spending money, which could help the economy and the markets in the long run, he said. Staff writer John Reid Blackwell and The Associated Press contributed to this report.