• All market eyes Tuesday will be on the release of the Labor Department's consumer price index, a widely followed inflation gauge.
• Economists are expecting that the CPI will show a 0.4% increase in January, which would translate into 6.2% annual growth. However, there's some indication the number could be even higher.
• The Federal Reserve is determined to keep fighting inflation, so the report could harden their position.

Just as Federal Reserve officials have grown optimistic that inflation is cooling, news could come countering that narrative.

All market eyes Tuesday will be on the release of the Labor Department's consumer price index, a widely followed inflation gauge that measures the costs for dozens of goods and services spanning the economy.

The CPI was trending lower as 2022 came to close. But it looks like 2023 will show that inflation was strong — perhaps even stronger than Wall Street expectations.

"We've gotten surprises on the soft side for the last three months. It wouldn't be at all surprising if we get surprise on the hot side in January," said Mark Zandi, chief economist at Moody's Analytics.

Economists are expecting that CPI will show a 0.4% increase in January, which would translate into 6.2% annual growth, according to Dow Jones. Excluding food and energy, so-called core CPI is projected to rise 0.3% and 5.5%, respectively.

However, there's some indication the number could be even higher.

The Cleveland Fed's "Nowcast" tracker of CPI components is pointing toward inflation growth of 0.65% on a monthly basis and 6.5% year over year. On the core, the outlook is for 0.46% and 5.6%.

The Fed model is based on what its authors say are fewer variables than the CPI report while utilizing more real-time data rather than the backward-looking numbers often found in government reports. Over time, the Cleveland Fed says its methodology outperforms other high-profile forecasters.

Impact on interest rates

If the reading is hotter than expected, there are potential important investing implications.

Fed policymakers are watching the CPI and a host of other data points for clues on whether a series of eight interest rate increases is having the desired effect of cooling inflation that hit a 41-year high last summer. If it turns out that monetary tightening isn't working, it could force the Fed into a more aggressive posture.

Zandi said, however, that it's dangerous to make too much of individual reports.

"We shouldn't get fixated too much on any month-to-month movements," he said. "Generally, looking through month-to-month volatility we should see continued decline in year-over-year growth."

Indeed, the CPI peaked out around 9% in June 2022 on an annual basis but has been on the decline since, falling to 6.4% in December.

But food prices have been stubborn, still up more than 10% from a year ago in December. Gasoline prices also have reversed course, with prices at the pump up about 30 cents a gallon in January, according to AAA.

Even the initially reported 0.1% decline in the headline CPI for December has been revised up, and is now showing a gain of 0.1%, according to revisions released Friday.

"When you've had a string of lower-than-expected numbers, can that continue? I don't know," said Peter Boockvar, chief investment officer at Bleakley Advisory Group.

Boockvar said he doesn't expect the January report to have a lot of influence on the Fed one way or the other.

"Let's just say the headline number is 6%. Is that really going to move the needle for the Fed?" he said. "The Fed seems intent on raising another 50 basis points, and there's clearly going to be a lot more evidence needed for them to change that. One number is certainly not going to do that."

Markets currently expect the Fed to raise its benchmark interest rate two more times from its current target range of 4.5%-4.75%. That would translate to another half a percentage point, or 50 basis points. Market pricing also indicates that Fed will stop at a "terminal rate" of 5.18%.

Changes in the CPI report

There are other issues that could cast a cloud over the report, as the Bureau of Labor Statistics is changing the way it's compiling the report.

One significant alteration is that it is now weighting prices on a one-year comparison rather than the two-year duration it had previously used.

That has resulted in a change in how much influence the various components will have — the weighting for both food and energy prices, for instance, will have an incrementally smaller influence on the headline CPI number, while housing will have a slightly heavier weighting.

In addition, shelter will have a heavier influence, going from about a 33% weight to 34.4%. The BLS also will give heavier price weighting to unattached rental properties, as opposed to apartments.

The change in weightings are done to reflect consumer spending patterns so the CPI provides a more accurate cost-of-living picture.