Investors’ eyes are on inflation this week after dismal jobs report

The stakes just got higher for this week’s inflation report.

The US economy lost 23,000 jobs in July, the Bureau of Labor Statistics reported on Friday, perhaps signaling that the labor market could be trending in an unhealthy direction.

The update may change the calculus for the Federal Reserve, which will next decide on interest rate policy at its September 16 meeting. The Fed has a so-called dual mandate: on one side, it aims to maintain stability in consumer prices by keeping inflation in check; on the other hand, it needs to support demand enough to keep the labor market humming.

So far, freshly minted Fed chair Kevin Warsh has emphasized in stern tones his goal of fighting inflation, which has remained above the central bank’s 2% target. But the ugly July jobs report may force Warsh to pull back on his hawkish rhetoric and look more closely at the labor market part of the Fed’s mandate.

That means all eyes will be on July’s CPI report on Wednesday morning, as investors look for clues on what the Fed will do next. Ordinarily, a softening labor market would mean cooling inflation data, but elevated energy prices are complicating things.

Economists expect July’s CPI to come in at 3.4% year-over-year, down from 3.5% in June and 4.2% in May. As of Friday afternoon, market odds have the Fed keeping rates unchanged in September, but are still pricing in one to two hikes before the end of the year despite the ice-cold jobs report.

Here are two scenarios that could play out this week after we see updated inflation numbers on Wednesday:

• Inflation is hot, stocks drop

This is maybe the market’s worst-case scenario: a stagflationary outcome. Investors are hoping the weak July jobs report has given the Fed the ammo it needs to cut rates. That’s why stocks soared on Friday — bad news is good news right now when it comes to payrolls.

But given Warsh’s outspokenness about fighting inflation, a hot report may prompt him to hike rates despite the weak jobs outlook. Either way, it’s hard to imagine a scenario where stocks rise if inflation comes in higher than expectations. Unlike with the jobs report, bad news is bad news for CPI.

• Inflation is cool enough, stocks soar

It’s unlikely that inflation drops below the Fed’s goal of 2%, but investors may cheer on anything in the low 3s or below as a signal that consumer price growth is coming down and the Fed can cut rates comfortably, or at least stay put.

Even the latter scenario could reverse expectations for hikes later this year that are already priced in, allowing investors to relax a bit.