Wall Street is currently fixated on the prospects for inflation, and for good reason.

Inflation has a huge impact on stock valuations.

Stock prices are based primarily on the present value of future streams of cash flows thrown off by the investment. In other words, you buy a stock today for tomorrow's cash flows.

Stock prices are based primarily on the present value of future streams of cash flows thrown off by the investment. In other words, you buy a stock today for tomorrow's cash flows.

Now, if you believe inflation is going to increase, what does that do to the future value of cash flows? It reduces their value. And if the future value of cash flows is reduced, that means those cash flows are worth less in today's dollars, too. And, to continue the thought, that means that a company's stock is worth less.

I know this seems a bit complicated, but here's an easy way to look at inflation and stock prices. A stock's price/earnings ratio is a barometer for how much investors are willing to pay for a company's growth prospects. If you believe a company is going to grow quickly in the future, you are willing to pay up for that growth. Paying up for growth means buying stocks with high price/earnings ratios. Now, if inflation is going to erode the value of that growth, you won't be willing to pay as much for the growth because it will be worth less in a high-inflation environment. That means price/earnings ratios fall.

See the relationship? Lower inflation means higher price/earnings ratios and higher stock prices. Higher inflation means lower price/earnings ratios and lower stock prices.

Now it should be clear why inflation is so important to investors (and to the Federal Reserve Board). If inflation were to take off, that would have a dramatic impact on price/earnings ratios of stocks. And since price/earnings ratios, on average, have never been higher, the squeezing of price/earnings ratios from higher inflation would have a devastating impact on stock prices.