Read: Inflation hits 39-year high in November

“Their eyes are wide open right now for sure,” Shapiro said.

The critical point, Shapiro said, is that inflation so far has been a matter of the price of goods.

But it looks like inflation is about to jump off the rails into the service sector where labor costs make up the bulk of prices. If labor costs accelerate given the recent spike in inflation, the Fed will face “a very uncomfortable situation,” he said.

For years and years, labor costs have been under an “iron grip” but the pandemic has turned the tide, he said.

Faced with these new risks, the Fed will begin a journey towards a more neutral policy next week.

The Fed has conducted an extremely accommodative monetary policy, buying billions of dollars in bonds each month as part of a quantitative easing policy. Next Wednesday, the Fed is expected to double the rate of tapering of its asset purchases so that the program ends in March, a few months earlier than expected.

Fed officials will issue a policy statement and new economic projections next Wednesday at 2 p.m. Wednesday. Fed Chairman Jerome Powell will follow with a press conference at 2:30 p.m.

The unspoken message is that the Fed will be ready to start raising interest rates sooner as well, Shapiro said.

“I think they’re going to start making rate hikes of 25 basis points per meeting in the second quarter,

“It doesn’t make sense to have interest rates where they are right now – both on the price front and on growth – zero sense, and they’ve held them too long to begin with,” Shapiro said.

David Wilcox, a former Fed member and now a member of the Peterson Institute for International Economics, said it was important to view Fed policy as a thermostat with many settings rather than just an on-off switch.

So next week, the Fed will turn the dial to a less accommodative policy.

They will do this by forecasting a faster “take-off” in interest rates and a faster trajectory over the next three years than in September.

“What they’re doing isn’t ending their support for the economy. They’re just going backwards,” Wilcox said in an interview. Besides continuing to buy assets until March, the sheer size of the Fed’s balance sheet resulting from the purchases gives the economy a boost, he argued.

In September, the Fed’s dot-plot forecast for interest rates showed only one rate hike next year. Projections showed a gradual increase in the fed funds rate to just 1.8% by the end of 2024.

This is below the 2.5% federal funds rate that the Fed considers “neutral”, neither slowing the economy nor stimulating growth.

Wilcox said it was plausible that the updated dot plot would show the Fed will achieve neutrality by the end of 2024.

US government debt yields TMUBMUSD10Y,
1.453%
were mostly lower on Friday morning, despite the consumer inflation reading which hit its highest year-on-year rate in nearly 40 years.