Inflation Slowed to 3.5% in June, but How Long Will It Last? Here's What Investors Need to Know.

The Consumer Price Index (CPI) -- the government's main inflation gauge -- fell 0.4% from May, its largest month-over-month drop since April 2020. That pulled the annual inflation rate down to 3.5%, from 4.2% the month before.

Economists had expected a more modest monthly drop of 0.2%, and for the annual rate to land at 3.8%, so the report came in well ahead of what Wall Street was bracing for. That being said, inflation is still well above the Federal Reserve’s target of 2%.

The good news sent stocks higher. As of 2:50 p.m. on Tuesday, the S&P 500 (SNPINDEX:^GSPC) is up 0.42%, while the Nasdaq Composite gained 1.00%.

Core inflation held steady as energy prices tumbled

Core inflation -- which strips out food and energy, the two most volatile categories -- was flat on the month. Economists had expected a 0.2% rise. This brought the annual core rate down to 2.6%, from 2.9% in May.

Most of the dramatic reduction came from one category: energy. The category is running hot after the Iran war sent oil prices soaring. Prices have retreated, however, and fuel oil fell 9% from May while gasoline fell 10%. Overall, energy posted a 5.7% reduction from May.

Fed Chair Warsh tempers enthusiasm over inflation progress

The report also landed on the same morning that new Fed Chair Kevin Warsh gave his first congressional testimony since taking the reins. Speaking before the House Financial Services Committee, Warsh was quick to tamper any excitement over the better-than-expected results. "There might be some that look at this morning's data and say, 'Oh, mission accomplished, everything is swell.' That is not my view," he told lawmakers.

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Warsh told the committee that rising prices had placed an "undue burden" on American households and businesses, and repeated his commitment to getting inflation back to the Fed's 2% target. He said he was open to using both interest rates -- the most visible tool the Fed has at its disposal -- and its balance sheet -- an equally powerful tool sometimes overlooked by casual investors.

Warsh also laid out changes to how the Fed communicates, something he’s been talking about for some time. This included fazing out forward guidance -- the practice of signaling in advance where rates are likely headed.

What investors should watch next

While the lower-than-expected inflation report is good news for the stock market, the fact is that inflation remains much higher than the Fed would like. The main question right now -- the question the Fed is actively debating -- is how much of today’s inflation is transitory?

The huge jump in inflation last month — the reading was at 4.2% — was driven largely by energy, and, in turn, so was this month’s drop. If oil prices continue to fall, there is a chance that inflation could cool naturally, and the best course of action for the Fed would be to sit on its hands.

That’s a big if, however. If the fighting in Iran escalates and pushes oil prices higher again, as it has in the last few days (though nowhere near their earlier highs), June's progress could reverse in a hurry.

Johnny Rice has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.