Reasons for the Stock Market's Negative Reaction to the Latest Inflation Data

The stock market is experiencing another bout of volatility.

 

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

 

The consumer price index for August indicated that prices increased by 2.5% annually, according to the Bureau of Labor Statistics. This marks the lowest headline inflation rate since early 2021. However, core inflation, which excludes the volatile food and energy sectors, exceeded expectations by rising 0.3% for the month, compared to the projected 0.2% increase.

 

Investors are concerned about this unexpected rise in core inflation, as it suggests that inflation remains persistent enough to likely prevent a 50 basis-point rate cut at the Federal Reserve's next policy meeting, which some investors had been hoping for.

 

Following the CPI report, the market now sees an 83% chance that the Fed will opt for a 25 basis-point rate cut next week, an increase from the 56% odds a week ago, as indicated by the CME FedWatch tool.

 

"Another month, another slightly awkward data point," Julian Howard, the chief multi-asset investment strategist at GAM Investments, noted in a statement, adding that core and services inflation appeared "firmly unvanquished" in the latest figures.

 

"However, it does seem at least that a full 0.5% cut just became a little less convincing. Apart from anything else, the Fed's dual mandate means that it can't build its case for an aggressive or any cut solely around a weakening labor market," he added.

 

Although markets are disappointed about the reduced likelihood of a larger cut, a 50 basis-point move by the Fed would be a double-edged sword. Cutting rates by 50 basis points could have signaled to markets that the Fed is worried about a significant economic slowdown, analysts have noted in recent weeks. Conversely, a smaller 25 basis-point cut implies prolonged higher interest rates.

 

Investors are paying close attention to the job market for additional signs of weakness. Jobless claims on Thursday will be the next labor market indicator ahead of the Fed meeting next week.

 

"The job market will continue to be an influence," Gina Bolvin, president of Bolvin Wealth Management Group, said in a statement. "Today's inflation data solidified a 25 basis-point cut for next week; 50 basis points is off the table," she added.

 

Housing costs were a major factor in driving inflation higher, with the Labor Department noting that shelter inflation rose by another 0.5% in August.

 

Shelter costs may soon decline, as market rent growth is estimated to be around 2% year-over-year, according to Preston Caldwell, a US economist at Morningstar.

 

"As long as this remains in place, housing inflation will inevitably have to fall," he stated in a note.

 

Even after adjusting their expectations, markets still anticipate moderate rate cuts from the Fed by the end of the year. Investors are pricing in an 84% chance that the Fed will cut rates by 100 basis points or more by December, though future rate cuts will depend on jobs and inflation data.

 

"If the economy continues to slow—without plunging into a sudden recession—the Fed will be able to cut rates at a steady 25 basis points per meeting pace," Chris Zacarelli, chief investment officer of Independent Advisor Alliance, noted in a statement.

 

"Given the current situation, with the Fed cutting rates, unemployment near multi-decade lows, and an expanding (though slowing) economy, the market should be able to achieve all-time highs again, once we navigate through the volatility that usually comes before most presidential elections," he added.