Last Friday's US employment report fell significantly short of expectations, sharply increasing the importance of the consumer price report due out this week. The Bureau of Labor Statistics reported a loss of 23,000 non-farm jobs in July, suggesting the labor market may be shifting in an unhealthy direction. This outcome has altered the market's calculations regarding the Federal Reserve's policy path. The next Fed rate decision is scheduled for September 16th.

The Federal Reserve is balancing a dual mandate: maintaining price stability through inflation control while supporting demand to keep the labor market healthy. Newly appointed Chair Kevin Warsh has previously taken a strong hawkish tone on combating inflation, which remains above the 2% target. However, the weak July jobs data may force Warsh to moderate his hawkish stance and pay more attention to the employment side of the mandate.

Investors will be closely watching the July Consumer Price Index (CPI) on Wednesday. Normally, a softening labor market leads to cooling inflation, but high energy prices are currently complicating the picture. Economists forecast a 3.4% year-on-year increase in July CPI, down from 3.5% in June and 4.2% in May. As of Friday, the market still expects the Fed to hold rates steady in September, but continues to price in one to two rate hikes before year-end, despite the evident cooling in jobs data.

Two possible scenarios may emerge following the release of this week's inflation data. Scenario one involves a stock market decline if inflation remains stubbornly high. This is the stagflation outcome the market fears most. Investors had hoped the weak jobs report would provide the Fed with room to cut rates, which drove a stock market rally on Friday—where "bad news is good news" for employment data. However, if inflation proves stronger than expected, Warsh's hawkish stance could still push for a rate hike, even with a poor employment outlook. For CPI, bad news is unambiguously bad news, making it difficult for the stock market to rise under these conditions.

Scenario two involves a stock market rally if inflation cools sufficiently. The probability of inflation falling below 2% is low, but if the data comes in slightly above 3% or lower, investors may interpret it as a sign that price increases are decelerating. This would allow the Fed to feel comfortable cutting rates, or at least maintaining its current stance. Even a hold on rates could reverse market expectations for further rate hikes later this year, offering investors a degree of relief.