By Howard Schneider

WASHINGTON, (Reuters) – Federal Reserve officials are facing a clock to their ability not to ignore high inflation. They now have to navigate between their own senses and risks and a U.S. economic system that is tangled with supply chains, slow employment, and strong consumer demand.

A combination of supply shortages and an increase in household incomes due to pandemic-related government assistance drove the personal consumption expenditures prices index (a key indicator of inflation) up to its highest level in 30 years in August.

The majority of policymakers expect price rises to continue at their current pace, even if the Fed does not raise interest rates earlier or higher than they expected.

But that judgement now rests on the outcome of a race. Can disruptions such as that of the Los Angeles-Long Beach port facility in California with its 100-ship backup disappear before the $2 trillion worth of excess savings that households have accumulated since the pandemic? What about the public’s expectations of future inflation in the face of recent price rises?

This may be already happening. The Fed’s index of inflation expectancies, which is monitored by high-ranking officials at the U.S. central banking, has increased for five consecutive quarters. It is at 2.06% which is higher than the Fed’s target of 2% and will likely rise. The consumer expectations are also rising. On Tuesday, The Conference Board announced that the Conference Board’s 1-year survey of consumer inflation for October reached 7.0%. This is the highest level since July 2008.

Inflation is also anticipated by bond markets. They are pricing a quicker start and slower pace for Fed interest rate rises.

“Early on, patience was easy,” Fed Governor Randal Quarles said last week https://www.federalreserve.gov/newsevents/speech/quarles20211020a.htm. The fundamental problem we are facing… is that the demand, which has been augmented with unprecedented fiscal stimulus, has outstripped a temporarily interrupted supply. The economy’s fundamental capacity remains intact and Fed officials are keen to maintain low interest rates as much as possible in order to allow employment to rise.

Quarles explained that “continguishing the demand, in order to bring them into line with an intermittently interrupted supply now would be premature”, however, “my focus is starting to turn more fully… whether inflation begins to descend.”

Tension in the Air

Next week, the Fed will hold a policy meeting and announce its plans to end $120 billion monthly asset purchases in 2022. The Fed will decide if it accelerates its goal of raising the target rate to near zero between now and next year based on inflation and inflation expectations and job growth.

One year ago, prior to the introduction of COVID-19 and the onset of an epidemic of infectious diseases, it seemed impossible that higher borrowing costs would be possible. Only four Fed policymakers anticipated the need to increase rates prior to 2024.

Half of 18 policymakers now expect a rise in the 2022 budget. This would be despite Democratic President Joe Biden funding new spending. It is likely that this move will come before pre-pandemic employment levels have returned. It could be a problem for Democrats trying to hold control of Congress at the Nov. 8-2022 elections.

Fed Chair Jerome Powell noticed the tension emerging between central banks’s inflation and job goals. Richard Clarida Fed Vice Chair was asked April by Powell when he thought the Fed’s “transitory inflation” expectation might be incorrect. Clarida replied that it would “the beginning of the year.” Last week, Chris Waller, Fed Governor set the same timeframe.

Peter Ireland from Boston College, an economics professor said “We appear to be at an impasse and the question remains whether some of our old problems will come back to haunt”

Fed officials tried to make it a less difficult choice by creating a new policy framework to help them capture the job gains they missed during past business cycles, when interest rates were too high.

This framework is dependent on inflation and job markets being the same as before. This premise is now in doubt, at least for the time being.

The Fed’s “transitory inflation” narrative has been stretched by things other than a global shortage of computer chips, warehouse capacity limitations, and other supply problems. It is also clouded by the actions of elected officials and households.

Feeling ‘burned?

Biden’s future spending will not reach the level of early 2021 when federal payments helped increase household incomes, despite wide-ranging joblessness. Its projected decline may cool demand.

Some pandemic programs are still in place. The debate over whether they should be made permanent, or if other infrastructure spending and social spending is ongoing. Recent research from San Francisco Fed staff https://www.frbsf.org/economic-research/publications/economic-letter/2021/october/is-american-rescue-plan-taking-us-back-to-1960s argued that between the spending already in train and the fact that job vacancies have surged beyond the number of unemployed looking for work, “the economy may already be in a heated state” with inflation heading higher, even if only temporarily.

Surveys and data from other sources point to the exact same conclusion. The Fed may lose the surge in workers and job growth they have hoped for to increase production and reduce price pressures, but it is unlikely that this will happen soon.

Statistics compiled by the Atlanta Fed https://www.atlantafed.org/chcs/labor-market-distributions and the Kansas City Fed https://www.kansascityfed.org/data-and-trends/labor-market-conditions-indicators show job markets generally tighter than reflected in the current 4.8% headline unemployment rate or the roughly 5 million jobs still missing from the February 2020 workforce.

Indeed, a job site found that the most important reasons for not looking urgently for work were cash buffers and being in a family with a spouse. This could indicate a slow return to normal if preference has shifted towards working less. A St. Louis Fed study found that 2020 would see 3 million extra retirements. This number is likely to account for the majority of people still not in the workforce.

Fed officials are now more open to the possibility that inflation, which they believed they have defeated, will return faster than they expected.

Ethan Harris (NYSE:), global economist, wrote that “It is obvious that the Fed feels burnt by the previous business cycle.” Although interest rates were increased, inflation did not reach the Fed’s target of 2%. Potential job gains were also left out.

Harris noted that there are many challenges facing the Fed’s narrative, including possible changes in household preferences and restructuring due to the pandemic.