Wednesday’s Inflation Data Could Send Stock Market on Another Wild Ride

It has been a long time since Wall Street’s attention was this focused on inflation data.

After years of very low inflation, many now believe that a combination of low unemployment and robust economic growth could start to push prices higher. The deep cuts in corporate, small business, and individual taxes may also accelerate the economy and trigger inflation.

As a result, Wednesday’s report on the consumer price index will be closely watched and has the potential to move the stock and bond markets. The consensus of economists polled by Bloomberg forecasts consumer prices to rise 0.3 percent compared with the previous month and 2.0 percent year-over-year. Core consumer prices, which excludes volatile energy and food prices, is expected to grow 0.2 percent on a monthly basis and 1.7 percent year-over-year.

Higher inflation would not necessarily be unwelcome. The Federal Reserve says it targets two percent inflation–a number it has consistently undershot since the Great Recession. But bond investors, who receive fixed coupon payments, fear that inflation will devour their upside, which is why bond prices may fall and yields rise if inflation comes in higher than expected.

Investors in stocks are not directly exposed to inflation in the same way. Some companies may even do better with more inflation. But investors worry that higher inflation will drive up interest rates, making borrowing more expensive and slowing the economy. What’s more, higher inflation could trigger the Federal Reserve to raise its target rate in an effort to put the brakes on the economy. In the worst case scenario, the Fed could overreact to inflation numbers and push the economy into a recession.

This was the scenario that seemed to trigger the recent bout of stock market volatility, sending bond yields up and stocks down.

There is a bit of a self-correcting aspect to this process, which helps explain some of the ups-and-downs we have seen in markets in the past two weeks. Fears of an economic slump–or even slumping stock prices–can send investors into bonds, which then go up in price, driving down yields. Falling yields then make stock market returns more attractive and ease financial conditions on businesses, sending investors back into stocks.

On Tuesday, the stock market went into a kind of holding pattern. Stocks slumped slightly but did not experience anything like the sell-offs of last week. Bond yields fell, too, climbing down after rising on Monday.

The Fed says it watches core inflation, so investors are likely to focus on that number on Wednesday. Any move higher than 0.2 percent over last month’s prices may cause the market to convulse. As well, a significant undershoot could crush fears of inflation and send stocks higher.