By Howard Schneider

WASHINGTON, (Reuters) – The Federal Reserve will raise interest rates March 1, based on the belief that the U.S. economy can largely avoid the Omicron coronavirus fallout and continue growing at a healthy pace.

But what if it does?

With financial markets fast adapting to expectations of an ever-more aggressive Fed battle against inflation, year-end data showed weaker-than-anticipated results for some of the inflation measures the U.S. central bank watches closely, a reminder of how uncertain its ultimate policy path remains.

These numbers are still very high. The employment cost index (the broadest measure for labor costs) rose 4% year-on year in the fourth quarter. This was the largest increase since 2001. In December, personal consumption expenditures price index jumped 5.8% year-on year. It is the highest annual jump since 1982, nearly three times the Fed’s inflation target of 2%.

However, the rate of change in the past periods was slower than the current period. Analysts and investors continued to pencil in faster Fed Rate increases for this year. Some added a footnote.

According to Ian Shepherdson (chief economist at Pantheon Macroeconomics), the slowdown in growth in unemployment costs was “a big step in the right direction” and reassured Fed officials that they expect prices trends to improve on their own.

Jerome Powell, the Fed chair, and the other U.S. central banks officials, have stressed the possibility that inflation could prove to be higher than expected and required them to increase borrowing costs sooner than anticipated. Shepherdson, however, has recently forecasted a different view. Shepherdson sees an economy where the coronavirus pandemic causes an economic flatline, which results in fewer jobs and an inflation rate that “falls sharply” in the second quarter. This is just as the Fed is likely gearing up for future interest rates.

This scenario is out of line with the five expected rate increases this year by investors and forecasters, some of whom have guessed as high as seven. It also shows how uncertain the Fed’s response to the economic outlook and where it will go.

“NO ROADMAP”

At this stage, a Fed interest rate increase at its March 15-16 policy meeting seems almost certain. But even the size of that increase is up in the air as some analysts expect the Fed, rather than the usual quarter-percentage-point rate hike, to opt for a larger half-percentage-point rise to tighten credit faster and demonstrate its seriousness in lowering inflation.

However, much depends on the behavior of the economy, the financial markets, and the virus in the coming weeks.

On Friday, major U.S. stock indices traded higher. This was a relief after a week of severe losses. The U.S. Commerce Department had earlier reported that December saw a decline in consumer spending. This weakness may have been sustained into January due to the large number of coronavirus infections.

According to the University of Michigan, the University of Michigan closely monitors American household sentiment. Consumer sentiment fell further at the beginning of the year. It reached its lowest level in 10 years. Richard Curtin (survey director) said Omicron, high inflation, and constant news about Fed rate rises might trigger a consumer backlash, which could be detrimental to economic growth. This is on top of lower government spending.

Curtin warned that “consumers may react excessively to these small nudges.”

The Fed could be able to help curb inflation. Some of this was due to strong demand during the pandemic. But the Fed is likely to be balancing the need for price control and overreach.

“Anxiety has set in within the Fed’s ranks. “The challenge is now to reduce inflation while not allowing the flame to go out on the entire economy,” said Diane Swonk chief economist of Grant Thornton, an accounting firm. After inflation surged, there isn’t a roadmap for how to do this.

Some signs of caution were evident in bond markets Friday. U.S. Treasury yields declined and the gap between shorter-term and longer-term securities narrowed. This is often interpreted as a lack of confidence in future economic growth or falling inflation.

Neel Kazhkari, Minneapolis Fed president, stated that either way it is an indication that the U.S. central banking may not have to “slam the brakes” by imposing aggressive rate increases.

NPR heard Friday from Kashkari that despite the Fed’s apparent hawkish position, the goal is to not slow down recovery but instead “let our feet off the accelerator just slightly.”