Why the stock market reacts negatively to new inflation data

The stock market is going through another period of instability.

 

US indices fell on Wednesday, with the Dow dropping as much as 600 points in the early hours as traders processed mixed inflation data.

 

The Consumer Price Index for August showed prices rose 2.5% year-over-year, according to the Bureau of Labor Statistics. That's the lowest rate of core inflation since the start of 2021. However, core inflation, which excludes the volatile food and energy sectors, beat expectations, rising 0.3% for the month, compared with a projected 0.2% increase.

 

Investors are concerned about this unexpected increase in core inflation because it indicates that inflation remains resilient enough to likely prevent the 50 basis point rate cut at the next Federal Reserve meeting that some investors had hoped for.

 

Following the CPI report, the probability that the Fed will opt for a 25 basis point rate cut next week increased to 83%, up from 56% a week earlier, as the CME FedWatch tool showed.

 

"Another month, another slightly awkward data point," Julian Howard, chief multi-asset investment portfolio strategist at GAM Investments, said in a statement, adding that core and services inflation likely remained flat in the latest data.

 

"However, the full 0.5% rate cut seems to have become less convincing. Among other things, the Fed's dual mandate means that it cannot base its argument for an aggressive or any rate cut solely on a weakening labor market," he added.

 

While markets are disappointed with the reduced likelihood of more rate cuts, a 50 basis point move by the Fed would be a two-pronged stick. A 50 basis point rate cut could signal to markets that the Fed is concerned about a significant economic slowdown, analysts have said in recent weeks. In contrast, a smaller 25 basis point rate cut would imply a prolonged continuation of high interest rates.

 

Investors are watching the labor market closely for additional signs of weakness. Thursday's jobless claims will be the next labor market indicator before next week's Fed meeting.

 

"The labor market will continue to have an impact," Gina Bolvin, president of Bolvin Wealth Management Group, said in a statement. "Today's inflation data reinforced the expectation of a 25 basis point rate cut next week; 50 basis points is no longer on the table," she added.

 

Rising home values have been the main factor pushing inflation up, with the Labor Department noting that housing inflation rose another 0.5% in August.

 

Housing costs may soon decline as market rent growth is estimated at about 2% year-over-year, according to Preston Caldwell, an economist at Morningstar USA.

 

"As long as this stays in place, housing inflation should inevitably fall," he said in a note.

 

Even after adjusting their expectations, markets still expect moderate rate cuts from the Fed by the end of the year. Investors rate the probability that the Fed will cut rates by 100 basis points or more by December at 84%, although future rate cuts will depend on jobs and inflation data.

 

"If the economy continues to slow - without suddenly plunging into recession - the Fed could cut rates at a steady pace of 25 basis points at each meeting," Chris Zacarelli, chief investment officer at Independent Advisor Alliance, said in a statement.

 

"Given the current situation with the Fed cutting rates, unemployment at multi-year lows and a growing (albeit slowing) economy, the market should be able to hit new all-time highs once we get through the volatility that typically precedes most presidential elections," he added.