The Federal Reserve's primary inflation rate, the core PCE price index, fell to a 2% annualized rate in the third quarter, according to new revisions from the Commerce Department. This unexpectedly tepid inflation data is adding to expectations that the upcoming November inflation data will also be subdued. As a result, the S&P 500 witnessed an increase while the 10-year Treasury yield dropped.

The decline in inflation to the Fed's 2% target during a period of strong economic growth helps explain why policymakers are becoming less concerned about an inflation resurgence.

Financial markets are now predicting that the Federal Reserve will cut its key policy rate to 3.8% by the end of 2024, down from 3.83% prior to the release of the revised PCE and GDP data. The rapid decline in inflation is making the current 5.25% to 5.5% range of the federal funds rate seem increasingly restrictive.

Market pricing now indicates an 83% likelihood that the first rate cut will occur at the March 20 meeting, up from 79% on Wednesday. Furthermore, markets see a 42% probability of a 1.75 percentage point cut in rates in the coming year, an increase from 38% the previous day.

The level of Fed monetary policy tightness is determined by the real federal funds rate, which measures the extent to which the key interest rate exceeds the inflation rate. In the third quarter, the real federal funds rate ranged between 3.25% and 3.5%. This contrasts with the Fed's long-term estimate of the neutral policy rate, which is 0.5% above their 2% inflation target. The neutral rate neither restricts nor boosts economic growth.

Turning to November data, the consumer price index showed a 0.3% month-on-month increase in core prices. However, the producer price index released prior to the Fed's December 13 policy statement and projections suggested a softer reading for the core PCE price index. This likely influenced Fed Chair Jerome Powell's dovish outlook.

The consensus estimate for November is a 0.2% rise in core prices, which would bring down the annual core PCE inflation rate to 3.4% from October's 3.5%. However, forecasts for the monthly increase in the core PCE price index range from 0% to 0.2%, indicating a high likelihood of a positive surprise.

Meanwhile, the headline PCE price index, which includes food and energy, is expected to remain unchanged from October, resulting in an annual increase of just 3%.

Although the annual inflation rates may fall below the pre-revised GDP forecast, the core PCE price index for Q3 rose at an annualized rate of 2%, revised down from 2.3%. The headline PCE inflation was also revised to a 2.6% annualized rate, down from 2.8%.

The revised GDP data showed that the economy grew by 4.9% in Q3, slightly lower than the previous estimate of 5.2%, primarily due to more moderate estimates of consumer spending.

Looking ahead, the Commerce Department's monthly personal income and outlays release on Friday will provide November's inflation data. Economists are predicting a 0.4% increase in personal income and a 0.3% rise in spending.

The trend of disinflation and solid growth appears to have continued into the fourth quarter. Additional data released on Thursday showed a slight increase of 2,000 in initial claims for jobless benefits in the week ending December 16. However, the four-week average decreased by 1,000 to 212,000, slightly above January's record low of 199,500.

The S&P 500 rose by 0.6% in Thursday's morning trading, rebounding from the 1.5% decline on Wednesday. This bounce-back follows a 16% rally since October 27, bringing the S&P 500 within close proximity to its January 3, 2022 record close.

This rally in the S&P 500 coincided with a significant drop in the 10-year Treasury yield, which has a direct impact not only on mortgage rates and auto loans but also on stock valuations. Analysts use the 10-year Treasury yield as a risk-free rate for discounting future earnings. As the yield decreases, the future earnings of growth companies appear more appealing.

On Thursday, the 10-year Treasury yield reached as low as 3.83%, a level last observed in late July. However, it ultimately settled at 3.87%, down only one basis point from Wednesday.