Another bout of inflation fear offset an avalanche of solid earnings results Wednesday, sending the stock market down sharply.

After two days of modest gains, major averages returned to last week's losing ways -- and the pattern of heavy late-day selling -- despite a fresh batch of solid earnings and positive guidance from the likes of

Caterpillar

(CAT) - Get Report

,

General Dynamics

(GD) - Get Report

and

Wyeth

(WY) - Get Report

, as well as Tuesday night's strong reports from

Intel

(INTC) - Get Report

and

Yahoo!

(YHOO)

.

The

Dow Jones Industrial Average

lost 114 points, or 1.1%, to close at 10,013, while the

S&P 500

fell 15 points, or 1.3%, to 1138, marking fresh year-lows for both indices. The

Nasdaq

lost 18 points, or 0.9%, closing at 1914, still above its recent low of 1908.

Stocks were held back early in the day by the Labor Department's consumer price index report, which rose 0.6% in March, slightly higher than expectations. But the core index, which excludes food and energy, rose 0.4%, double expectations.

The market was able to absorb the CPI data without much damage but endured a second wave of selling after the 2 p.m. release of the Fed's Beige Book, which noted that: "Price pressures have intensified in a number of Districts, and most report that high or rising energy prices are a concern across sectors."

The combination of the CPI and beige book news revived fears of inflation and/or that the

Federal Reserve's

tightening will be more aggressive, potentially squashing economic growth. The data ultimately overshadowed the mainly positive corporate news.

Breadth was negative with decliners beating advancers by more than 3 to 1 on the

NYSE

and slightly less than 3 to 1 on the Nasdaq. But volumes of 1.4 billion on the Big Board and of 1.7 billion on the Nasdaq remained too light to make the case for broad-based capitulation.

Wednesday's afternoon selling could continue tomorrow, if overnight earnings, March leading economic indicators, the April Philadelphia Fed index or the latest weekly jobless claims figure spook the market one way or another. (After the bell Wednesday,

eBay

(EBAY) - Get Report

posted better-than-expected results and

Motorola's

(MOT)

outlook was solid. But

Qualcomm

(QCOM) - Get Report

slashed its 2005 guidance.)

"I'm on mini-crash alert," says Raymond James equity strategist Jeffrey Saut. "Real bottoms don't really give room to get comfortably long, yet many participants still are. I don't like the tone of it."

After getting an oversold reading three weeks ago, Saut went long -- only to see the market unable to rally even as crude oil prices fell. "I got stopped out," he says. Now he's still waiting to see a bit "more panic in the white of participants' eyes" before putting his money back into the market.

Inflation Shoes Drop

So what should be made of the inflation numbers?

The CPI may not be as bad as thought, at least according to some economists. The headline index was slightly above expectations. But soaring energy prices, including a 7.9% jump in gasoline prices, were already expected and priced in by economists and Wall Street.

But it was the CPI's core component, which excludes food and energy, that spooked the market.

Wachovia economist Jason Schenker points out that the Fed is now going to have to walk a fine line between growth and inflation. A few more months like this, he says, and the Fed's measured pace of tightening may be abandoned.

Clearly, the bond market was first shaken by the number, as the benchmark 10-year Treasury fell sharply in morning trade while its yield rose to as much as 4.29%. The 10-year came back in the afternoon as selling intensified in the equities arena. The note finished the day with a slight gain, with its yield falling back to 4.19%.

But how much of an impact will the March CPI really have on Fed policy?

"Fed policy will not be changed in any way whatsoever by this," says Moody's chief economist John Lonski.

Overall, the trailing 12-month rate of increase in core inflation is edging lower at 2.3% in March, compared with 2.4% in February. "Core inflation is just about right at 2% to 3%," says Moody's Lonski. "It's like blood pressure. You don't want it too high or too low."

In December 2003, core inflation was dangerously low, making it hard for businesses to pass on higher costs, Lonski recalled. Given rising energy and health care costs, businesses today need that margin.

In addition, the March spike may be a seasonal factor, according to HFE's chief U.S. economist Ian Shepherdson. The culprit behind the surprise rise in core prices was a 3.9% surge in lodging costs. "It is possible that the early Easter explains the March leap -- hotels may have raised rates earlier than usual," says Shepherdson. "Either way, this is not a sign of impending stagflation."

Inflation concerns were heightened after the Fed rang the alarm bells at its March 22 meeting. But since then, March's anemic payroll growth, slowing retail sales and an ever-rising trade deficit had economists revise downward their growth expectations. While noting the expected price pressures from rising energy prices, the beige book also pointed out that many districts appear concerned about the possible negative impact of energy prices on growth.

"In two-thirds of the districts, retail or tourism contacts expressed concern that high energy prices were already, or could soon be, damping consumer demand," the report read.

At this point, whether the "soft patch" remains a temporary phenomenon or whether inflationary pressures first catch up to the Fed remains uncertain.

In the meantime, market participants may feel as if they're being played like yo-yos, bouncing from concerns of a slowdown to fears of inflation, all the while trying to throw some pennies into the mouths of elusive winning stocks at the Wall Street fair.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send

your feedback.