Traders are watching to see if March consumer inflation data will run hotter than expected Wednesday, just as producer prices did Tuesday.
The consumer price index is reported at 8:30 a.m. ET. It is expected to be up 2.4 percent on a year-over-year basis in March and 2.1 percent on core, which excludes food and fuel. That compares with a 1.8 percent increase in core CPI in February. Core is expected to rise 0.2 percent on a monthly basis.
"I think there is definitely the possibility for a surprise to the upside," said Peter Boockvar, chief investment strategist at Bleakley Financial Group.
The market has been volatile based on headlines about tariffs and trade disputes lately, but the potential for more rapidly rising interest rates has also been a concern. A jump in inflation could be a sign that the Fed would have to raise interest rates more rapidly if it begins to run above its 2 percent target.
While the markets watch CPI, the Fed favors the PCE deflator, which is still running below its target.
Producer prices are watched as a measure of what might ultimately show up in consumer inflation. The core producer price index Tuesday was up 3 percent, excluding food and energy, compared with expectations for 2.9 percent year over year.
"Net, net, the economy is generating some heat with inflation at the producer level picking up. Will it lead to more consumer inflation? Commodities are 25% of core CPI purchases," wrote Chris Rupkey, chief financial economist at MUFG.
Rupkey notes that CPI was depressed by a drop in cell phone rates last February, but that will drop out of the CPI data in March, and that helps the comparison from last year's level.
"Time will tell if the fuse is lit and the clock is ticking for higher inflation that prompts a faster path for interest rate hikes from Fed officials seeking to thread the needle and balance supply and demand pressures in this long-dated economic expansion. Policy is always a balance between too hot and too cold and right now the Fed's policy is running the economy a little on the hot side," he noted.
But the jump in inflation is unlikely to do much to move the Fed forward any faster with its rate hikes at this point.
"I think there is a general consensus that CPI is biased a bit higher particularly on a year-over-year basis because of some of the base effects. That said, I don't think it is really going to be strong enough to recalibrate the market's expectations in terms of the Fed," said Ian Lyngen, head of U.S. rate strategy at BMO.
Lyngen said he expects the Fed to hike three more times this year, once each quarter, while the Fed forecasts two more hikes.
"There's always a debate about what the lag is between changes in PPI and final consumer prices. I think there's a case to be made that margins are pretty high for corporates right now and the tax cut means there's some cushion to play with in after-tax earnings. I wouldn't be surprised to see companies absorb some of the rise in producer prices," said Michael Gapen, chief U.S. economist at Barclays.
But Gapen doesn't see much of a pickup in the consumer-related categories in PPI, and he doesn't necessarily see pressure mounting for consumer prices yet.
"We think you'll be moving toward 2.4 percent on CPI and 2 percent on PCE and be just short of those by year-end. We think we're going to move up from here. Some of that improvement is just a washing out of base effect. The other expected improvement is from fiscal stimulus and some demand-side impulses," he said.
The Fed has forecast two more rate hikes for this year, and Gapen said he is watching the Fed's minutes from its last meeting, due at 2 p.m. Wednesday, to see if it suggests it could revise its rate forecast later in the year.
"What I will be watching for is really the discussion around the balance of risks. On one side, you have anti-trade. On the other side, you have a lot of fiscal stimulus. Over time, one of these is going to win out. It looks like their forecast is dependent on the idea that fiscal stimulus is going to win out," he said, adding the Fed could then have to revise higher its rate forecast.