Did the Stock Market Celebrate Too Early on Monday?

Wall Street finished Monday in a good mood, with huge gains for major market benchmarks. The Dow Jones Industrial Average (^DJI -0.51%), S&P 500 (^GSPC -0.27%), and Nasdaq Composite (^IXIC -0.18%) all finished with gains of more than 1% as investors seemed to anticipate positive news coming out over the course of the remainder of the week.

Data source: Yahoo! Finance.

In particular, there are two events that investors seem to assume will work out well for them. On Tuesday morning, the Bureau of Labor Statistics will release the latest readings on the Consumer Price Index for November, and market participants will be watching closely to see if inflation shows any signs of continuing to slow. Indeed, the Federal Reserve will also be watching that CPI report as it begins two days of deliberations that will culminate in a decision on short-term interest rates Wednesday afternoon.

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Will prices keep rising?

The first key information investors will get is the CPI report on Tuesday at 8:30 a.m. ET. With plenty at stake, a favorable number will be essential if the stock market wants to continue its upward path from Monday.

Economists believe that the monthly CPI number is likely to go up between 0.3% and 0.4%. That would produce a year-over-year rise in the price index of about 7.3%, which would be somewhat slower than the 7.7% gain between October 2021 and October 2022.

A considerable portion of the volatility in this measure of consumer prices comes from the food and energy categories. Notably, changes in prices of key commodities, like gasoline, often have extreme impacts on monthly price figures, so many investors take those two categories out and focus instead on what they call the "core" CPI. Economists expect a roughly 0.3% rise in the core CPI, which would mean that the index will have risen by 6.1% year over year, down slightly from the 6.3% annual rise as of October 2022.

Market watchers will look more deeply into the numbers, focusing on a couple of aspects of the report. First, if prices of goods moderate while prices of services continue to rise more sharply, it could raise fears that wage gains could make it more likely that inflation rates above the Fed's 2% target will become entrenched. Also, extreme surprises in either direction could affect predictions for what the Fed will do later in the week, which, in turn, could move markets.

Will the Fed keep hiking?

Investors are fairly confident in expecting higher interest rates from the Federal Reserve when its monetary policy committee meets Tuesday and Wednesday. The open questions are, how big a rate hike will the Fed likely make and what signals will it likely to send to help investors anticipate what's coming in 2023.

December's Fed meeting follows four consecutive increases of three-quarters of a percentage point, but the majority view is that the central bank will slow down its pace of rate hikes and settle for a half-point increase this month. That will still raise the federal funds rate to a new range between 4.25% and 4.5%, its highest level since 2007. Still, a significant minority of market participants expect a fifth-straight three-quarter-point increase, to a new range of 4.5% to 4.75%.

The Fed's goal with its rapid rate increases has been to crush inflation before it becomes entrenched. Regardless of what it does this month, though, there'll be a lag between its monetary policy actions and their impact on prices.

Ordinarily, the Fed would face the conundrum that aggressive rate increases boost the chance of recession. However, market participants know that the central bank won't flinch, even if it hurts the economy. Investors need to read the intricacies of the language the Fed uses in projecting its future course of action to get a better sense of what to expect in 2023.

Banking on a good outcome

With the market's gains today, investors seem to expect moderating inflation and a smaller rate hike on Wednesday. Those expectations aren't unreasonable, but they open the door to disappointment if the numbers don't go the market's way.