By Howard Schneider

WASHINGTON, (Reuters) – Federal Reserve officials will face a challenge this week in trying to keep inflation under control and give the economy time to recover the lost jobs since the pandemic.

Investors are betting that the Fed will increase rates two times next year. This is a faster and more predictable pace than the policymakers have predicted. Economists at Goldman Sachs have been the most recent to speed up their rate rise call. They have moved it forward a whole year until July 2022.

Jan Hatzius (Goldman economist) and other Goldman experts wrote then that inflation measured by the core personal consumption expenses price index was still above 3%. It is an unprecedented run of inflation and one far above the Fed’s 2% target.

The labor market and especially the participation rate in the labor force are not likely to be at pre-pandemic levels. They would also appear to still fall short of “maximum employment”, which the Fed promised before increasing interest rates. The Goldman team stated that Fed officials will “conclude most, if not all, of the remaining weakness at labor force participation to be structural or voluntary” and then proceed with rate increases to ensure inflation stays under control.

“Since the (Federal Open Market Committee) last met in September, the unemployment rate has fallen further https://www.reuters.com/world/us/us-job-growth-slows-sharply-september-unemployment-rate-falls-48-2021-10-08, average hourly earnings and the employment cost index have posted strong increases https://www.reuters.com/article/idCAKBN2HJ1N8?edition-redirect=ca, inflation has remained high,” they wrote, challenging the Fed’s narrative that inflation will pass on its own without using a rate increase to tighten credit conditions and slow business and household purchases.

COLLAPSING TIPABLE

This week’s Fed meeting will see a new policy declaration issued by the Fed at 2 pm (1800 GMT). A press conference at 2:30 pm (1830 GMT) will follow. Fed Chair Jerome Powell will be speaking at this time. Officials will approve plans to reduce their $120 billion monthly bond purchase. This would be a step back from core policies that were put into place to combat the economic consequences of the pandemic.

Officials at the Fed have attempted to seperate that decision and their more important call about when to increase interest rates. Last year, the Fed established a benchmark rate for an interest rate increase when it stated that its policy rate would not rise until maximum employment was reached. “Inflation has now risen to 2 per cent and will moderately surpass 2 per cent for some time.”

Policymakers believed that they had enough time to phase out bond purchases eventually with very little inflation risk. Even when prices were rising earlier in the year Fed officials said that they would not be rushing to raise rates and claimed that high inflation was temporary.

However, the timetable may soon be in jeopardy.

According to Goldman economists, there is a seamless handoff between the bond taper and rate rises next year. This view mirrors that which prevails in the interest rates futures markets.

According to the CME Group’s (NASDAQ:) FedWatch https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html tool, trading in federal funds futures contracts now implies a greater than 65% probability that the Fed will raise rates in June, right as the taper is expected to end, with a second increase expected in November. Rates market indicators indicated that there was less than 20% chance of an increase in rates as early as June, and a comparable low probability of two increases next year.

TRANSITORY THESIS “NOT AGED WELL”

When it comes to inflation, it can seem confusing. The initial blame was placed on temporary supply disruptions, a surge in consumer spending for goods becoming more difficult to find in certain cases and the fact that inflation has continued to rise faster than anticipated.

Inflation in goods is expected to decrease next year and even reverse with a new round of falling prices. However, the price of services will make up any difference, especially if the recent rise in compensation for employees continues.

This will make it difficult for the central banks to assess whether wages and benefits have risen due to productivity rising or if the economy and labor market are out of balance.

Both would be considered positive developments, while the latter could raise inflation risk even further.

Powell is now in charge of the November meeting, a position that was not possible even weeks ago,” he wrote. He tried to find a balance between the people who are ready to increase rates next year and the ones willing to be patient.

He wrote that “none of these proves that transitory thesis” will eventually be false, however the “tests to believe that excessive inflation will likely prove temporary have not been well-received.”