The Fed rate cut is becoming more likely as traders await the key inflation report on Thursday.

• According to a survey by Dow Jones, economists expect the Consumer Price Index (CPI) to increase by 0.1% in June compared to May, and by 3.1% compared to the same month last year.
• This week, Fed Chair Jerome Powell testified on Capitol Hill for two days, and Thursday's report will follow.
• One chief investment officer suggests that monitoring shelter and medical care services may be crucial.

The upcoming inflation report on Thursday could strengthen predictions that the Federal Reserve will reduce interest rates in the near future.

The CPI report for June will be released at 8:30 am ET, and recent economic data suggest that inflation and economic growth are slowing down, including the report that unemployment in June increased to 4.1%.

Jerome Powell, the Fed Chair, delivered two days of testimony on Capitol Hill this week, but did not specify when rate cuts would begin. Despite this, Powell stated that the Fed sees the risks to the economy as more balanced between inflation and recession, and that the central bank does not need to wait until inflation reaches 2% before cutting rates.

What to watch for

According to a survey by Dow Jones, economists anticipate a 0.1% increase in the Consumer Price Index (CPI) on a month-over-month basis and a 3.1% increase on a year-over-year basis. The core CPI, which excludes volatile food and energy prices, is predicted to rise 0.2% from May and 3.4% since June the previous year.

In May, CPI remained stable compared to the previous month and increased by 3.3% yearly.

Matt Brenner, managing vice president, investments and product management at MissionSquare Retirement, stated that focusing on unemployment and inflation trends could strengthen the argument for rate cuts.

According to Brenner, the inflation rate remains above the Fed's target of 2%, while the unemployment rate is still historically low at 4.1%. However, both trends indicate that unemployment is gradually increasing and inflation is following a downward trajectory.

The Fed has been more focused on levels, but now it seems they may be shifting towards a focus on trend. If this is the case, then the chances of a rate cut increase, according to Brenner.

On Thursday, the focus will be on the changes in the components that make up the CPI index, especially if the number differs from expectations. Tony Roth, chief investment officer at Wilmington Trust, advised paying close attention to shelter and medical care services as key areas to watch.

The Fed's preferred inflation measure, the personal consumption expenditure index, includes both shelter and medical services in addition to CPI.

Roth stated that medical services have been relatively restrained, which is significant because they account for a larger portion of the PCE, which is the more significant of the two inflation measures.

Market impact

The CPI report comes as markets are on the upswing.

In July, both stocks and bonds experienced growth as traders' confidence in a rate cut increased. On Wednesday, the S&P 500 surpassed 5,600 for the first time.

The CME FedWatch Tool indicates that traders anticipate the Fed to maintain rates at its upcoming meeting, followed by a reduction in September, according to recent fed funds futures pricing. A month ago, the likelihood of a pause in September was nearly 50/50, as per the same tool, which calculates implied probabilities based on 30-day fed funds futures.

Meghan Swiber, a rates strategist at Bank of America, stated in a note to clients on Wednesday that the expected hold in July could prevent Thursday's CPI report from significantly impacting the market.

Swiber advised that market response should be limited due to the implementation of cooling activities and restrictions on near-term cut pricing.

If inflation readings are cooler than expected, stocks could rally, as some investors still have fears from earlier this year when inflation was hotter.

Roth stated that the market may not have fully recognized the economic weakness and the fact that inflation is no longer a concern, according to him.

— CNBC's Michael Bloom contributed reporting.