By Howard Schneider

WASHINGTON, (Reuters) – While the Federal Reserve won’t raise interest rates before March, officials are already using tougher language regarding inflation. Borrowing costs have risen for all, from homeowners to the Federal Government and the stock market, kicking off the year in the red.

The pace of that adjustment now poses an unexpectedly urgent question for U.S. central bank officials at their latest two-day policy meeting this week: Are financial markets tightening too fast for what the Fed intends in its inflation battle, or is the Fed the one underestimating what will ultimately be needed to slow the pace of price increases https://graphics.reuters.com/USA-FED/INFLATION/zdpxoqkrkvx/index.html?

In their most recent projections, issued in December, policymakers said they expected as many as three quarter-percentage-point rate increases this year, with more in the cards in 2023 and 2024. However, these projections do not elevate the Fed’s benchmark overnight rate of interest above “neutral”, which could actually limit the economy.

But inflation is still falling, which analysts consider unrealistic.

It is experiencing the greatest inflation rate since 1982. There is strong evidence to support that this will continue. Ethan Harris, head of global research for Bank of America (NYSE) wrote that the Fed has not responded as slowly to inflation before and is even signaling a benign rising cycle. “The greatest immediate risk to our future is that the Fed is behind the curve. It must get serious.”

He said that this could lead to six quarter-percentage rate point increases in the rate and an immediate push for a 3% Federal Funds Rate, which is a rapid increase from the level of near zero. This would be the most aggressive policy rate the Fed has slashed since 2007-2009, when it began to reduce borrowing costs. It is also enough to curb inflation, economic growth and employment, according to current estimates.

According to the Fed’s projections, they do little more than that.

Officials from the Fed won’t be updating their formal outlook during the policy meeting on Jan 25-26. After the publication of Wednesday’s policy statement, Fed Chair Jerome Powell will host a press conference to discuss the Fed’s plans and current outlook on the economy. The Fed has seen a more drastic 7% decrease in its equity value since Dec. 31.

“SHADOW” RATE HIT HIKES

A central bank which had promised support open to all until the economy recovered from the coronavirus outbreak a few months back, was shocked by the sudden surge in U.S. Inflation that reached a record 40 year high. This prompted a major policy shift away pandemic support.

The COVID inflation surge The COVID inflation surge https://graphics.reuters.com/USA-FED/INFLATION/akvezawxopr/chart.png

An “increase” in interest rates is being discussed for March. This was years before what was expected at the beginning of the crisis. At the same time, the Fed is planning to shrink https://graphics.reuters.com/USA-FED/BALANCESHEET/byprjmwezpe/index.html its holdings of U.S. Treasury bonds and mortgage-backed securities – using a second lever to ratchet up the cost of credit.

It is still a matter of discussion and analysis how the policy tools interact. The same goes for inflation. That variable, which the Fed eventually aims to control, remains the subject of much debate.

Investors are still assuming that the Fed will need to do more than three rate hikes and a less balanced balance to get price rises back in line with the Fed’s 2% inflation target. Futures trading linked to federal funds rates shows that there are four expected rate hikes this year and an increasing trend towards five.

Rising rates https://graphics.reuters.com/USA-FED/RATES/zgpomaxjqpd/chart.png

According to Fed officials’ comments and the sharp tone from minutes from its Dec. 14-15 meeting the interest rates on home mortgages, corporate credits, and U.S. Treasury bonds are now rising.

Since the Fed started cutting its monthly bond purchases last autumn and because of the increased concern about inflation, indicators that measure overall financial conditions have been slightly tightening. The Atlanta Fed has calculated the shadow federal funds rate and found that it had already produced an equivalent to a rate increase of 0.6 percent as a result of changes in interest rates.

OMICRON DRAG

However, financial conditions overall remain remarkably stable by historical standards. Even though this may seem out of line with inflation, there is still reason for Fed officials to be cautious about rapid change.

It continues to be a pandemic. Although some experts expect that the Omicron-related outbreak will recede soon, it is slowing down hiring and hampering economic recovery.

According to some economists, the U.S. would lose jobs in February and January. In the face of falling employment, the Fed would have to raise interest rates for March.

Even Omicron-related temporary “dips” keep alive the concern that Fed officials this year may face the worst. This could be a slowing economy or inflation, which will require even more severe medicine than the Fed has yet been prepared to provide.

Raphael Bostic, Atlanta Fed President, stated that the extent to which inflation is falling on its own without any Fed policies to slow it down, was part of the problem.

This could occur if the virus subsides or more people return to work.

However, there is no guarantee.

The Fed had been fighting against the dynamics of inflation that prevented it from reaching its target of 2% before the outbreak. Bostic stated that there was a narrative saying that once the pandemic is over, those forces will take control so that the Fed doesn’t have to be as assertive in their policy. However, “none” of the people who entered into the pandemic anticipated that inflation would rise to such an extent. The question is, “How forceful or fervently should we respond?”