Investors are pricing in much higher odds the Fed dials down the size of the next rate hike after October inflation cooled below 8%

Still-hot inflation is at its lowest since February and investors now see an 81% probability of a Fed rate hike of 50 basis points in December.

• Investors on Thursday were pricing in higher expectations the Federal Reserve will reduce the size of its rate hikes at its December meeting. 
• Inflation cooled to 7.7% in October, fueling greater speculation for a rate hike of 50 basis points at the December 13-14 meeting. 
• The Fed has raised the fed funds rate by 75 basis points at each of its past four meetings. 

US inflation rose by less than anticipated in October, spurring investors on Thursday to price in expectations the Federal Reserve will reduce the size of its hefty rate hikes at its final meeting of 2022. 

The CME FedWatch tool showed an 80.6% probability of a rate increase of 50 basis points at the Federal Open Market Committee's December 13-14 meeting, up from 58.6% a day ago. 

The central bank last month delivered its fourth consecutive rate hike of 75 basis points as part of its fight to ease inflation levels. After Thursday's inflation reading, the odds of another rate hike of that size next month tumbled to 19.4% from 43.2% a day prior. 

Inflation as measured by the Consumer Price Index rose 7.7% year over year, the Bureau of Labor Statistics said. The rate was lower than the 8% estimate in a Bloomberg survey of economists. Headline inflation in September was at a 40-year high of 8.2%. 

Core CPI, which strips out food and energy prices, increased 6.3% from a year ago, below expectations of 6.5%. 

"Investors got a really nice beat on CPI this morning driven by goods 'deflation' and medical costs; markets are reacting strongly in kind," Cliff Hodge, chief investment officer at Cornerstone Wealth, said in a note. "There's no question this release is a welcome sight at the Fed, which now have room to step down the pace of hikes to 50 basis points in December and potentially less in 1Q." 

However, "talk of a pivot is still premature," he added. "The Fed will need to see further evidence in coming months that inflation will continue slowing back toward target." 

To bring inflation toward its 2% target, the Fed has raised the benchmark rate six times in 2022, to a range of 3.75% to 4%. The fed funds rate was 0% at the start of the year, brought down to that ultra-low level when COVID began spreading worldwide in 2020. 

Stock futures shot up after Thursday's inflation report. The S&P 500 jumped 4.2%, and the Nasdaq Composite soared 5.6%. The Dow Jones Industrial Average leapt by 859 points or 2.6%. The 10-year Treasury yield sank by 31 basis points to 3.83%.

"The [inflation] rate is lower than expectations and this will provide some relief to consumers and the wider market; however it is worth noting food and shelter is still increasing, so not completely out of the woods yet," Stuart Clark, portfolio manager at Quilter Investors, wrote.

"The jobs market remains strong, so for as long as inflation is this elevated and the economy doesn't completely grind to a halt, the market will have to wait for any indication of a pivot or pause from the central bank."