Small caps pulled off their lows midday though remained besieged in the red after a government issued consumer spending report showed a sizeable jump in inflation and after Europe’s largest bank HSBC reported a dismal quarter, warning for continued challenges near term. Traders were also treading carefully ahead of the Federal Reserve’s Federal Open Market Committee meeting Tuesday.

At 12:30 p.m. ET, the Russell 2000 (NYSE:IWM) was down 8.87, or 1.24% at 707.29, while the Dow has managed to eclipse the green, up 4.89, or 0.04%, to 11,331.21.

This morning’s personal income report from the Commerce Department highlighted the threat of inflation. While personal income clocked in better than expected at an increase of 0.1% compared with the forecast of a decline of 0.2%, the inflation portion of the report showed the year-over-year PCE price index soared to 4.1%-- the highest rate in 17 years. The rise in personal income was the smallest rise since April 2007 and was owed mostly to the increase in gas prices.

Investors have become increasingly skittish about the threat of inflation, as rising energy prices have served to crimp consumer purse strings and this report served to play to that fear.

With the limelight on the personal income report, investors paid little attention to the better-than-expected factory orders report, which came in at 1.7%, above the consensus forecast for a rise of 0.7%.

The Federal Reserve holds its monthly policy meeting Tuesday and is widely expected to hold the Fed Funds target steady at 2%. Investors will focus on the central bank’s comments in light of anemic second-quarter GDP data and continued inflation fears.

“With personal spending higher than expected in June and a likely upward revision to inventories, U.S. GDP for Q2 is likely to be revised north of 2%,” Andy Busch, global foreign exchange strategist for BMO Capital Markets said in an email. “This will make it very difficult to get the wheels rolling on the ‘recession procession’ of market participants clamoring for a Fed rate cut.”

This week is central bank meeting week, as Reserve Bank of Australia, Bank of England and the European Central Bank are also meeting and are expected to keep key interest rates intact at current levels. These countries suffer a similar economic plight to the United States-- slow or negative growth coupled with high inflation.

The dollar is mixed against the euro, the yen and the pound in midday action. 

“This is a race to the economic bottom for monetary policy and the winner should see their currency appreciate,” Busch said. “I continue to stick with my call that the U.S. economy will bounce sooner and therefore see the currency appreciate as we head into the fall.”

Meanwhile crude oil has plunged $4 midday to roughly $120 per barrel, as a new storm brewing in the Gulf of Mexico showed that it likely will not damage oil and gas facilities in the Gulf. Rising output from OPEC on the supply side and pinched demand from major customers tied to high prices and soft economic growth has also had the bears on deck.

In corporate news, HSBC Holdings (NYSE:HBC) reported a 28% decline in first half profits and reported a hefty $14 billion debt write down tied to bad U.S. home loans and other asset losses.

In broader industry groups, office supplies, printing and publishing and airlines are among the few groups treading in the green mid-session, while coal, metal mining and oil and gas are the leading laggards at this time.

In major small cap market action, Charlotte Russe Holding Inc. (Nasdaq:CHIC) has swooned some 22% to a 52-week low after Roth Capital downgraded the clothing retailer to “sell” from “hold.” Additionally, the company announced after Friday’s close its chief financial officer, Patti Johnson, would step down effective Aug. 14. FreightCar America Inc. (Nasdaq:RAIL) is off some 21% midday after announcing ahead of the opening that it swung to a loss in the second quarter, while analysts had been expecting a profit.

On the upside, PeopleSupport, Inc. (Nasdaq:PSPT) has soared almost 26% after the offshore business process outsourcing provider said this morning that it will merge with Aegis BPO, part of Indian conglomerate Essar Group, through a $250 million cash transaction.