By Howard Schneider

WASHINGTON (Reuters) – The Federal Reserve on Wednesday is expected to detail plans to end its pandemic-era bond purchases by mid-2022 as policymakers shift their focus towards what, if anything, to do about a surge in inflation that is lasting longer than anticipated.

Investors in recent weeks increased bets that inflation will force the U.S. central bank to increase interest rates sooner rather than later, and Fed officials increasingly have acknowledged those risks.

The economic environment, however, is also fluid as central banks around the world plot their exits from loose pandemic-era policies. European Central Bank President Christine Lagarde, however, said on Wednesday the ECB was “very unlikely” https://www.reuters.com/business/finance/ecb-very-unlikely-raise-rates-next-year-lagarde-says-2021-11-03 to raise rates in 2022 despite high inflation – undercutting market bets it might lift borrowing costs as soon as October.

Lagarde’s comments may have eased some of the pressure on Fed Chair Jerome Powell. Yields on 2-year U.S. Treasuries fell, and trading in federal funds futures, according to the CME Group, shifted to reflect expectations the Fed would only raise rates twice next year instead of three times as was expected earlier this week.

The announcement of a bond-buying “taper” may be the central policy step taken by the Fed on Wednesday. U.S. central bankers, in the minutes of their Sept. 21-22 meeting, signaled they would in November or December begin reducing their current $120 billion in monthly asset purchases by $15 billion per month, ending the program altogether in June or July.

(For graphic on Fed balance sheet by era – https://graphics.reuters.com/USA-FED/TAPER/xmpjolmanvr/chart.png)

Of more note now is whether the Fed changes other parts of its policy statement to take more account of inflation risks, and particularly whether it alters the description of inflation as “largely reflecting transitory factors.”

Fed officials still largely hold the view that through 2022 global supply bottlenecks will ease, pandemic-fueled demand for goods among U.S. consumers will cool, and enough people will want to return to jobs that wage and benefit increases will also subside.

But a jump in inflation this year has already lasted longer than anticipated; headline rates are twice the Fed’s 2% target; and rising rents, low business inventories, and large numbers of workers on the sidelines may mean the high pace of price increases will continue for now.

(For graphic on “Broad-based” or not? “Broad-based” or not? – https://graphics.reuters.com/USA-FED/INFLATION/klpykzrowpg/chart.png)

The dilemma facing the U.S. central bank is whether inflation eases before policymakers feel compelled to step in with rate increases to curb it. Fed officials as of September were split over whether there would need to be a rate increase in 2022 even as markets have priced in multiple hikes.

The Fed cut its overnight benchmark federal funds interest rate to the near-zero level last year in a bid to stem the economic fallout of the pandemic.

“Will they hold on to the transitory description of inflation? My best guess is they will,” in order to keep their commitment to push the U.S. economy back to full employment, said Aneta Markowska, an economist at Jefferies. “If they were being intellectually honest they would probably drop it, but given what is happening in the market the Fed has to tread carefully.”

Push back too hard on the current market expectations, by emphasizing the 5 million U.S. jobs still missing from before the pandemic, and it could “unhinge” the market outlook for inflation, she noted. Lean too hard on inflation risks, and it could push rate hike expectations higher, possibly restricting credit and slowing the economy.

EYES ON POWELL

The Fed is due to release its policy statement at 2 p.m. EDT (1800 GMT). It will not issue new economic forecasts, so beyond the statement it will be up to Powell in his news conference half an hour later to balance the central bank’s mandated goals of achieving maximum employment and stable prices.

It will be a critical communications moment for Powell, whose term as Fed chief ends in February 2022. The White House has yet to announce whether the former investment banker will be reappointed to a second term, though President Joe Biden said on Tuesday an announcement of his nominations to fill top Fed positions would be made “fairly quickly.”

Through much of the pandemic, Powell’s bias – and that of most other Fed policymakers – has been in favor of the job market, in line with a new central bank strategic approach emphasizing employment and allowing higher inflation.

The Fed currently says it will not raise rates until inflation has both risen to its 2% target, and is on track to exceed it “for some time.”

The policy has not been quantified in terms of how much or how long an overshoot of inflation is intended. While Fed officials have described achievement of the inflation benchmark as still “a ways off,” some note the averages are creeping higher already.

(For graphic on Inflation, on average Inflation, on average – https://graphics.reuters.com/USA-FED/FRAMEWORK/byvrjjmbkve/chart.png)

Inflation is not the only surprise. The labor market is also behaving in unexpected ways. Despite near-record job openings, labor force participation is improving only slowly – with workers by choice or family necessity taking more time to return to jobs, and using savings elevated by pandemic benefit payments to cover the bills.

The employment-to-population ratio is still 2.4 percentage points below where it was at the outset of the pandemic in February 2020, with less than half the ground covered to return to that level.

(For graphic on The jobs hole facing Biden and the Fed – https://graphics.reuters.com/USA-ECONOMY/JOBS/jbyprzlrqpe/chart.png)

Still, in announcing the eventual end of purchases of U.S. Treasuries and mortgage-backed securities on Wednesday, the Fed will also declare the economy has made “substantial further progress” in healing from the pandemic.

(For graphic on “Substantial further progress” for the Fed? – https://graphics.reuters.com/USA-ECONOMY/FEDPROGRESS/yzdvxmmmdpx/chart.png)

Debate will then turn to how much more the job market can improve, and whether COVID-19 has changed the economy in ways that mean higher inflation with fewer people working.

“If the Fed projects that inflation will not revert to target within a reasonable amount of time, then the Fed could step up the tightening schedule even if employment is short of the mandate,” Tim Duy, chief U.S. economist at SGH Macro Advisors, wrote ahead of the policy decision. “The Fed could tell this story after this week’s meeting. In practice, the Fed has made pretty clear it is waiting for more inflation data” to see if the “transitory” narrative holds.

(Reporting by Howard Schneider; Editing by Dan Burns and Paul Simao)