Stocks Rebound Despite Big Jump In June Inflation
Financial Shares Post Double-Digit Gains

By Steven Mufson and David Cho
Washington Post Staff Writers
Thursday, July 17, 2008

Consumer prices surged 5 percent over the past year, the Labor Department said yesterday, as inflationary pressures spread ominously beyond energy and food to other parts of the economy.

The report said consumer prices jumped 1.1 percent in June, the second-biggest monthly increase since 1982, and heightened concerns that the U.S. economy may be facing its worst bout of stagflation -- a combination of rising prices and sluggish growth -- in almost three decades.

Despite the worrying report on consumer prices, U.S. stock markets rebounded yesterday, led by a torrid advance in financial shares after Wells Fargo, the nation's second-largest mortgage lender, beat earnings expectations and raised its dividend, a sign that the big firm is confident about weathering the credit crisis.

The Dow Jones industrial average rose 2.5 percent, posting its best one-day gain since April. The Standard & Poor's 500-stock index, a broader measure, also gained 2.5 percent.

The rally was also spurred by news from the oil market, where prices fell sharply for the second straight day on signs of a weak U.S. economy and an Energy Department report that U.S. commercial stocks of petroleum increased last week. Crude oil prices on the New York Mercantile Exchange have tumbled about $11 a barrel in two days, though they remain at a historically high $134.60 a barrel.

Economic policymakers yesterday continued to try to restore public confidence in the nation's financial system, which has been shaken by losses in the housing market and other credit woes. Treasury Secretary Henry M. Paulson Jr. went to Capitol Hill in an effort to mollify House Republicans concerned that the Bush administration's plan to prop up mortgage giants Fannie Mae and Freddie Mac could lead to a taxpayer bailout.

The rising inflation numbers will complicate the job of regulators, in particular the Federal Reserve, and ensure that the economy will remain at the center of political debate in this election year. Newly released minutes of the Fed's June meeting showed that some members had favored a boost in interest rates "very soon" to combat inflation. The latest figures could increase the pressure on the Fed to do so.

"The Fed is in a bind," said Mark Thomas, a University of Oregon economist. "If they raise interest rates, that might slow economic growth, which is already fragile, and if they lower rates or hold constant, there's a danger of inflation accelerating."

The 1.1 percent rise in prices in June was almost double May's rate and more than offset a slight increase in wages. The only bigger increase since 1982 was the 1.3 percent rise after Hurricane Katrina in September 2005, the Labor Department said.

Volatile food and energy costs were the biggest causes behind the accelerating rate of inflation. Energy costs have jumped about 30 percent on an annualized basis since the start of the year. Food prices have increased at an 8 percent annualized rate during the past three months.

Other prices were also up in June, indicating that high prices for oil and other commodities are working their way through the economy. Transportation costs were up 3.8 percent last month; rents and the cost of education and other services rose briskly, too. Overall, core inflation -- which excludes food and energy -- increased 0.3 percent in June, a substantial increase over the previous four months.

But investors, buoyed by the Wells Fargo news, brushed off the inflation report and streamed to buy up stocks that were at the lowest level in years.

The S&P 500 Banks Index rose 23 percent, the biggest jump since September 1989. Share prices of Fannie Mae and Freddie Mac more than erased steep losses from Tuesday, with Fannie Mae surging 31 percent and Freddie Mac rising 30 percent.

Shares of Washington Mutual, the largest U.S. savings and loan, jumped 25 percent, while J.P. Morgan Chase and Bank of America, the nation's largest commercial banks, climbed 16 and 22 percent, respectively. Wachovia, which holds more deposits from Washington area residents than any other commercial bank, gained 16 percent.

Wells Fargo reported a second-quarter profit of $1.75 billion, or about 53 cents a share. That was 21 percent lower than its profit in the corresponding quarter a year earlier but exceeded the expectations of most Wall Street analysts, who had predicted a profit of 50 cents a share.

Even more encouraging to investors was the company's announcement that it would raise its dividend 10 percent, a move that reaffirmed a positive long-term outlook.

"It is not just talk," said Doug Roberts of New Jersey-based Channel Capital Research. "They are backing it up with a commitment to pay out more cash -- an important element when capital is scarce in the banking sector."

Many banks have been cutting their dividends in recent months as the credit crisis has sapped their reserves.

The news from Wells Fargo does not necessarily translate across all financial firms, analysts said. Wells Fargo generally avoided the riskiest types of mortgages that have affected firms such as Wachovia, Washington Mutual and Citigroup. The company said yesterday that it was moving to expand as its rivals falter.

"We are open for business and getting lots of it," Wells Fargo president and chief executive John Stumpf said. "We also continued to benefit from opportunities in this environment to gain new business and customers through selective acquisitions."

The Securities and Exchange Commission also helped fuel the rally in financial shares, analysts said. Under criticism for not being more visible during the credit crisis, the agency on Tuesday announced an emergency order aimed at halting an illicit type of trading called "naked short selling."

In a short sale, a trader borrows stock and then sells it, promising to buy it back at a certain time in the future. If the price goes down, the trader wins. If not, he loses. This kind of transaction is not illegal or unusual. But in a naked short sale, cash changes hands but no actual shares do, cutting out the regulated stock exchanges and making the practice illegal.

Beginning Monday, the SEC will crack down on naked short selling of shares in Fannie Mae and Freddie Mac as well as 17 large financial firms that deal directly with the Fed. The effort is intended to bolster investors' confidence in these firms and protect them from abusive trading practices, SEC Chairman Christopher Cox said during a conference call with reporters yesterday.

Naked short selling can exacerbate a sell-off in a bank's shares by sharply increasing the volume of shares being sold, agency officials said. "A run on the bank, which can take hold quickly, would likely be turbo-charged by illegal naked short selling," Cox said. He added that the emergency order was "essential . . . to ensure a fair market in both long and short sales."

The order, which requires short-sellers to show evidence of their transactions, will last 30 days but may be expanded to include all stocks and made permanent.

The shares of many of the firms shielded from naked short selling by the SEC's action had double-digit gains early yesterday. Lehman Brothers, for one, jumped 26 percent.

The SEC is also conducting several investigations into whether malicious traders used short selling and spread false rumors to drive down the share price of Bear Stearns, which nearly collapsed earlier this year. According to people familiar with the probes, the agency is also looking into trading of shares in Lehman Brothers, which has complained that short-sellers were illicitly driving down its share price and unjustifiably undermining confidence in the firm. The SEC has issued subpoenas to dozens of hedge funds in its probes.

Staff writers Renae Merle and Michael Fletcher contributed to this report.

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