Wall St Week Ahead-Middle East developments set to sway US stocks as inflation data adds wrinkle

* Oil prices in focus as Brent crude tops $80 a barrel

* CPI on Wednesday to give February inflation view

* Higher inflation could temper rate-cut hopes

By Lewis Krauskopf

NEW YORK, March 6 (Reuters) - Investors will seek signs in the coming week of how sprawling the war in the Middle East will become and how much it will disrupt energy supplies, as they chew over fresh inflation data.

A U.S.-Israeli campaign against Iran that entered its sixth day on Thursday was consuming markets, with a jump in oil prices headlining volatility across assets. U.S. stocks swung sharply following the Middle East escalation, leaving the benchmark S&P 500 down 0.7% for the week, as of Thursday. Earlier in the week, the Cboe Volatility index , Wall Street's most-watched gauge of investor anxiety, hit its highest level since November.

Investors were balancing the historic tendency for equities to rebound in the wake of major global developments against a lack of clarity about the Iran situation.

"This is a very big event and it seems incredibly uncertain where it's headed," said Rick Meckler, partner at Cherry Lane Investments. "To some extent, it's left investors as neither sellers nor buyers."

HOW HIGH WILL OIL PRICES GO?

One focal point for markets was the surge in energy prices stemming from the conflict and its significance for inflation and economic output. The fighting has paralyzed shipping through the Strait of Hormuz, a key artery for around a fifth of the world's oil and liquefied natural gas supply.

Brent crude on Thursday reached $85 a barrel, up from $70 before the weekend strikes. Higher oil prices can dampen the outlook for equities in several ways, including by translating into higher gasoline prices that weaken consumer spending.

In the near term, Michael Arone, chief investment strategist at State Street Investment Management, said changes in oil prices will be "a good barometer for whether risk assets will do well or they will do poorly." Oil breaching $100 a barrel, he said, would be a psychological milestone that "would spook markets more." Even with the weekly decline, the S&P 500 remained just over 2% from its all-time closing high set in late January.

Expectations of a solid economic backdrop and strong corporate earnings growth this year have fed optimism for stocks, countering worries about artificial-intelligence-driven disruptions and private credit.

Heading into next week, "developments in the Middle East will move really all financial markets," said Dominic Pappalardo, chief multi-asset strategist for Morningstar Wealth.

PAST AS PROLOGUE WITH INFLATION DATA?

Inflation data will also be in Wall Street's spotlight. The consumer price index for February is due on Wednesday, following a cooler-than-expected January report for the closely watched inflation measure.

CPI for February is expected to show a 0.2% increase on a monthly basis, according to a Reuters poll. Investors said markets may discount any report that is tame, because it covers a period almost entirely before the Middle East conflict. But a surprise spike in inflation could be particularly problematic.

"If we get upside surprises to the inflation data next week, that could further fuel fears about inflation expectations rising and that would be bad for markets," Arone said. "The concern is that higher oil prices will only feed into higher inflation dynamics going forward."

HIGHER INFLATION COULD THREATEN RATE CUTS

Such worries about energy-induced higher inflation have contributed to investors pushing back their estimate for the Federal Reserve's next interest-rate cut.

Expectations for a cut of at least 25 basis points at the Fed's June meeting have fallen to about 32%, according to CME FedWatch, down from 47% a week ago and 75% a month ago.

After the central bank lowered rates last year to shore up a weakening labor market, hopes for further easing this year of about two standard quarter-percentage-point cuts have been a crucial part of the bull case for stocks. Investors generally associate lower interest rates with higher prices for stocks and other assets.

"If we continue to see increasing energy prices sparking inflation concerns, it will be much more difficult for the Fed to implement those two forecasted rate cuts in 2026," Pappalardo said. (Reporting by Lewis Krauskopf; Editing by David Gregorio)