Cooling inflation report leads to higher stock gains

Stocks on Wall Street finished higher Tuesday after a report showed inflation cooled more than expected last month, cementing expectations that the Federal Reserve is about to dial down the size of its interest rate increases.

Stocks initially surged after the report, driving the Dow Jones Industrial Average more than 700 points higher, but then pared gains as analysts cautioned investors not to get carried away by hopes for an easier Fed, as they have in the past.

The S&P 500 ended 0.7% higher. An early- morning burst of 2.8% nearly vanished by lunchtime. It had already climbed 1.4% a day earlier, with much of that gain coming in the last hour of trading on anticipation of the inflation data.

The Dow Jones Industrial Average flipped briefly to a loss before ending 0.3% higher, while the Nasdaq composite rose 1% after shedding most of a 3.8% gain.

The source of all the action was data showing that U.S. inflation slowed to 7.1% last month from 7.7% in October and more than 9% in the summer. Although inflation remains painfully high, and shoppers continue to pay prices well above levels from a year ago, Tuesday’s report offers hope that the worst of inflation is over.

More importantly for markets, the slowdown bolstered investors’ expectations that the Fed will downshift to an increase of half a percentage point when it announces its next increase to short-term rates today.

“The market’s hanging onto what the Fed does,” said Michael Antonelli, market strategist at Baird, adding that Wall Street will be watching whether Fed officials acknowledge the latest evidence of declining inflation.

“Will that be part of their language?” he said. “And if they say, ‘yes, we see it, but that doesn’t change our mind at all,’ then they’ve told us that they still think they need to hike or that they need to stay at higher rates for longer.”

Such increases slow the economy by design, in hopes of cooling conditions enough to get inflation under control.

But the increases also risk causing a recession if rates go too high, and they push down prices for stocks and all kinds of other investments. Smaller increases to interest rates would mean less added pain to the economy and markets.

A half-point increase typically is a big deal because it’s double the usual move. But with inflation coming off its worst level in generations, a half-point increase equates to a step down from the four straight three-quarter-point increases the Fed has approved since the summer.

Expectations for an easier Fed meant some of Wall Street’s wildest action Tuesday was in the bond market, where yields fell sharply immediately after the inflation report’s release.

The yield on the 10-year Treasury, which helps set rates for mortgages and other important loans, fell to 3.51% from 3.62% late Monday. The two-year yield, which more closely tracks expectations for the Fed, dropped to 4.22% from 4.39%.

Other central banks around the world, including the European Central Bank, are also likely to raise their own rates by half a point this week.

Technology stocks helped push the S&P 500 higher. The benchmark index added 29.09 points to close at 4,019.65. The Dow rose 103.60 points to 34,108.64. The Nasdaq gained 113.08 points to finish at 11,256.81.

Small company stocks also gained ground. The Russell 2000 index rose 13.75 points, or 0.8%, to 1,832.36.

Despite the encouraging inflation data, analysts cautioned that the Fed’s fight against inflation — and its increases to interest rates — still has further to go. Even if the Fed is moving at smaller increments, it may still take rates higher than markets expect. Some investors continue to bet the Fed will cut interest rates in the latter part of 2023. Rate cuts generally act like steroids for stocks and other investments, but the Fed has been insisting it plans to hold rates at a high level for some time to ensure the battle against inflation is won.

And even if inflation is indeed firmly on its way down, the global economy still faces threats from the rate increases already pushed through. The housing industry and other businesses that rely on low interest rates have shown particular weakness, and worries are rising broadly about the strength of corporate profits.