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Published: Aug 10, 2022 5 min read

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Stocks jumped Wednesday morning after better-than-expected inflation data promised relief for consumers struggling to keep up with rising prices.

The consumer price index (CPI), a measure of price changes for a variety of goods and services, rose 8.5% in July from a year earlier, according to data from the Labor Department. It's a slowdown from June, when consumer prices increased 9.1% from the year before — the largest increase in four decades.

Investors, apparently, liked the latest inflation numbers. The S&P 500 jumped as high as 1.9% after the data was released on Wednesday morning, while the Dow Jones Industrial Average edged up around 1.6% and the Nasdaq Composite, more than 2%.

The lower-than-anticipated CPI data likely comes as welcome news to the Federal Reserve, which has been hiking interest rates to battle high prices. But what exactly does that mean for investors?

How inflation impacts stocks (and the Fed)

Investors aren't necessarily reacting to the inflation data itself, but rather to how the Federal Reserve is likely to react to the new report.

The central bank often increases short-term interest rates when inflation is high, in order to cool economic activity. The goal is to bring down prices while not cooling activity so much that the economy tips into a recession. Higher interest rates limit businesses and consumers' abilities to borrow and spend, which can bring down the price of goods and services, but can also crimp prices for financial assets like stocks.

Investors seem to be hoping that the recent data supports the notion that inflation has peaked, and therefore, that the Fed will be able to slow down its interest rate hikes.

What's next for inflation and the stock market?

Even before Wednesday's data, the stock market has been rallying from its dismal first half of the year. Jim Paulsen, chief investment strategist at The Leuthold Group, told Money earlier this week that the he believes the primary driver of the rally is that investors are buying into the idea that the "economic tightening cycle" is nearing a pause.

Not everyone is as optimistic. Scott Wren, senior global market strategist at Wells Fargo Investment Institute, wrote in a report Wednesday that he doesn't agree with the idea that the Fed will "pivot" and pause or reduce rate hikes this year.

"A sudden turnaround in headline inflation readings may prematurely push equity markets higher as investors believe the trend has turned lower for good," Wren wrote. "We do not believe inflation will fall as quickly as it has risen."

Kathy Jones, Charles Schwab's chief fixed income strategist, tweeted Wednesday that while the CPI data was "definitely good news" it's also just "one in a row."

"The Fed will need to see a series of numbers showing inflation is declining before it pivots," Jones wrote.

There is plenty of data expected between now and the next Federal Open Market Committee in September — when the Fed is expected to make a decision about the next possible rate hikes — she added. It's also important to keep in mind that even though inflation has slipped, it's still close to a 40-year high.

Overall, financial advisors tend to recommend that long-term investors not react to news with knee-jerk adjustments to their investment portfolios. A well-diversified portfolio and a strong investment plan that aligns with your goals, time horizon and risk tolerance is likely your best bet when it comes to building wealth via the stock market — no matter the Fed's next move.

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