An inflation report Wednesday should be a big deal for the Fed. Here's what to expect

An important inflation report Wednesday could give the Federal Reserve a little breathing room in its battle against inflation.

The consumer price index, due at 8:30 a.m. ET from the Bureau of Labor Statistics, is expected to show only a modest increase for July — 0.1% on the all-items headline number and 0.2% for the all-important core reading that excludes volatile food and energy prices, according to the Dow Jones consensus. On an annual basis, they are expected to show 3.4% and 2.5% respectively, both down 0.1 percentage point from June.

While that will still keep annual inflation rates well above the Fed's 2% goal, two straight muted monthly readings could help buy Federal Open Market Committee policymakers a little time before making a move on interest rates.

"If we get a July CPI report anywhere near my forecast, the balance of the committee is going to look right through the supply shock, and the FOMC will remain on hold for the remainder of the year," said Joe Brusuelas, chief economist at RSM. The data, he added, will provide "something of an assist" for Fed Chairman Kevin Warsh, who has faced stiff policy challenges since taking the post in May.

At its July meeting, the FOMC split in a 9-3 vote to hold its key borrowing rate unchanged at 3.5%-3.75%. The three dissenting voters all favored a quarter percentage point increase, and Governor Lisa Cook recently indicated that she, too, sees the need for hiking if the inflation data doesn't cooperate.

However, a recent spate of less-threatening numbers and back-and-forth signs of easing tensions in the Middle East have caused a repricing in market expectations. Traders now see the September meeting as presenting only a 50-50 chance for a hike, and see a better likelihood in October or December, according to the CME's FedWatch gauge.

Fed officials will have the advantage of taking in both the July and August inflation readings before meeting again. The central bank skips an August meeting as the Kansas City Fed hosts its annual symposium in Jackson Hole, Wyoming.

"If you're not confused, you're not paying attention," Brusuelas said. "That's a good synopsis of where we're at here in mid-August."

The economy is coming off a June that provided some welcome relief in the inflation numbers, with the headline rate down 0.4% on a monthly basis and core flat, largely due to receding energy prices and a moderation in shelter costs. At the same time, a report last Friday showed nonfarm payrolls fell by 23,000 in July even as the unemployment rate dropped to 4.1%.

Even with potential signs of a softening labor market, however, some economists are bracing for a potential upside surprise in the July data or at least indications that inflation is too stubborn for the Fed to ignore.

Bank of America, for example, is still calling for three rate increases in coming months. The firm's economists said in a client note that the July jobs report "didn't change the overall picture on the labor market — it's stable. And more importantly, the Fed's reaction function is heavily skewed towards the inflation data as noted by recent Fed speak."

Should the Fed's primary inflation gauge average 0.25% increases over the next two months, "it is all but guaranteed that the Fed will begin hiking rates in September," BofA said.