Don't expect the stock market to rally even as gas prices fall and inflation cools, Goldman Sachs says

• Falling gas prices mean inflation is set to cool considerably over the coming months, according to Goldman Sachs.
• Analysts expect lower gas prices to shave at least one percentage point off of headline CPI.
• But the stock market has limited upside as the Fed is unlikely to tolerate easing financial conditions with inflation still elevated, Goldman said.

In what will be seen as a relief to tens of millions of Americans, inflation is set to cool in the coming months, according to a Monday note from Goldman Sachs.

Specifically, Goldman economist Jan Hatzius explained that falling gas prices are set to shave at least one percentage point off of headline Consumer Price Index growth over the coming two to three months.

"The most immediate reason to expect disinflation is the nearly 20% decline in retail gasoline prices since mid-June, which still has further to run given the usual lags versus the wholesale market," he said.

That will no doubt be a big relief for consumers who have dealt with 40-year highs in inflation. The rise in inflation was partially driven by a steady increase in the average gas price, which surged above $5 for the first time ever earlier this summer. Today, the average price for a gallon of gas has fallen to $4.06, according to data from AAA.

Additionally, and "perhaps more importantly," supply delivery times are beginning to improve and easing supply chain pressures that plagued everything from semiconductor chips to garage doors over the past year should help slow down Producer Price Index inflation and soon result in lower core goods consumer inflation as well, according to Hatzius.

Lower inflation will be welcomed by both investors and the Federal Reserve, as it could give the central bank more flexibility in its current interest rate hike trajectory. In July, Fed Chairman Jerome Powell declined to provide guidance as to what it expects to do with interest rates at its September meeting and said it will instead rely on incoming data to make its decision.

If inflation readings show a marked decline in prices, it could lead the Fed to slow down its interest rate hikes from the recent 75-basis-point increase to 50 or even 25 basis points.

But investors shouldn't expect falling inflation to help push the stock market higher because the Fed still has a lot of work to do to get the current inflation rate of 9% back to its long-term target of 2%.

"We expect a large slowdown from the outsized [inflation] prints of the past two months, but it will probably take until early next year before sequential inflation slows sufficiently to persuade the Fed to stop hiking," Hatzius said.

That means that even as recession fears begin to ease and investors build hope of an early Fed pivot, a rising stock market will likely make the Fed uneasy.

"We don't see much potential for large further [stock market] gains because the Fed is unlikely to tolerate much easier financial conditions until inflation is clearly on its way back to 2%. Such a breakout would become even harder if oil prices rebound from their recent slump, as our commodity strategists predict," Hatzius said.