Here's why the stock market is throwing a tantrum about new inflation data

• Stock investors are less than pleased with August inflation numbers.
• Core inflation rose unexpectedly, dashing hopes for a bigger rate cut from the Fed.
• Traders are now grappling with the reality that rates are staying higher for longer.

The stock market is having another outburst.

US indexes slumped on Wednesday, with the Dow dropping as much as 600 basis points in the early morning as traders took a mixed-bag of inflation data.

The consumer price index for August showed prices grew 2.5% on a yearly basis, per the Bureau of Labor Statistics. That's the lowest headline inflation rate recorded since early 2021. However, core inflation, which excludes volatile food and energy prices, came in hotter than expected, rising 0.3% for the month, ahead of the estimated 0.2% increase.

Investors are freaking out over the upside surprise. It's a sign that inflation is sticky enough to take a 50 basis-point rate cut off the table at the Fed's next policy meeting, which some investors had been eagerly pricing in.

After the CPI reading, markets see an 83% chance the Fed will cut rates just 25 basis points next week, up from 56% odds priced in a week ago, according to the CME FedWatch tool.

"Another month, another slightly awkward datapoint," Julian Howard, the chief multi-asset investment strategist at GAM Investments, said in a note, adding that core and services inflation looked "firmly unvanquished" in the latest figures.

"However, it does seem at least that a full 0.5% cut just became a little less convincing. Apart from anything else, the Fed's dual mandate means that it can't build its case for an aggressive or indeed any cut solely around a weakening labour market," he later added.

While markets may be upset about the dimmer prospects of a bigger cut, a 50 basis point move by the Fed would be a potentially doubled-edged sword. Cutting rates 50 basis points could have alarmed markets that the Fed was worried about a meaningful slowdown in the economy, analysts have noted in recent weeks. On the other hand, cutting interest rates by just 25 basis points means higher for longer interest rates.

Investors are now paying extra close attention to the job market for signs of further weakness. Jobless claims on Thursday will be the next labor market input ahead of the Fed meeting next week.

"The job market will continue to be an influencer," Gina Bolvin, the president of Bolvin Wealth Management Group, said in a statement. "Today's inflation data cemented in a 25 basis point cut next week 50 basis points in out the window," she added.

Housing costs were the main factor that pushed inflation higher, the Labor Department said, noting that shelter inflation rose another 0.5% in August.

Shelter costs could soon see a decline, though, given that market rent growth is estimated to run at about 2% year-over-year, according to Preston Caldwell, a US economist at Morningstar.

"As long as this remains in place, housing inflation has to inevitably fall," he said in a note.

Even after reining in their expectations, markets are still expecting moderate rate cuts from the Fed by the end of the year. Investors are pricing in an 84% chance the Fed will cut rates 100 basis points or more by December, though future rate cuts will continue to be contingent on jobs and inflation data.

"If the economy continues to slow – and not drop into an abrupt recession – the Fed will be able to cut at a measured, 25 bps-per-meeting pace," Chris Zacarelli, the chief investment officer of Independent Advisor Alliance, said in a note.

"Given the current situation, with a Fed cutting rates, unemployment close to multi-decade lows and an expanding (although slowing) economy, the market should be able to reclaim all-time highs, once we get past the volatility that precedes most presidential elections," he added.