Markets Breathe a Sigh of Relief on Softer Core Inflation

Stocks rose after new data showed an improvement in the government’s measure of core inflation on Wednesday, even as the overall inflation rate rose thanks to a spike in energy prices. Investors have become more concerned about inflation over the past few months as price pressures have been sticky. The release of Wednesday’s December Consumer Price Index report helped alleviate some of that concern.

The Morningstar US Market Index rose 1.81% on the day. Even bigger gains came from the large-cap growth category, which close 2.67% higher. Gains in small-cap value were more muted, with that category up 1.57%.

Bonds rallied too, with the yield on the 10-year US Treasury note dropping from around 4.77% to as low as 4.65%. Bond yields move in the opposite direction of prices. Yields have been rising over the past few weeks, amid market expectations for sticky inflation and strong economic growth in the months ahead.

Why Are Stocks Up?

The December CPI report found that core inflation rose 0.2% for the month compared with 0.3% in November. That metric excludes food and energy prices, which can be volatile from month to month and distort long-term trends in price pressures.

“While the 0.1% difference may seem small statistically, it is having a significant impact on markets as it alleviates concerns around an unexpected spike in inflation,” explains Dominic Pappalardo, chief multi-asset strategist for Morningstar Investment Management.

With the Federal Reserve pausing its interest rate cuts, sticky inflation could have problematic implications. If price pressures remain too high, it could force the Fed to keep rates elevated for longer—a scenario that conventional wisdom says is less than ideal. The threat of an extended Fed pause or a less likely hike in the first half of 2025 has rattled investors.

“Market participants are inferring today’s more benign inflation print will allow the Fed to continue to lower interest rates which should be stimulative for the economy and financial markets as it lowers borrowing costs and the discount rate for future earnings,” Pappalardo says.

However, he adds that market projections for future rate cuts remain little changed. Investors still see a 98% chance that the Fed will hold rates steady at its upcoming January meeting, according to data from the CME FedWatch Tool, and they are not pricing in the possibility of another rate cut until at least June.

The Bottom Line for Investors

Uncertainty surrounding inflation, the path of the economy, the path of the Fed, and the wide range of possible policy changes from the incoming Trump administration has fueled a noticeable uptick in volatility in stock and bond markets compared with much of 2024.

Against that backdrop, Pappalardo encourages investors to keep the bigger picture in mind: “Heightened short-term volatility is likely to persist, and as always, we encourage investors to focus on longer-term trends as opposed to individual data points.”