The two major investment banks changed their forecasts following data showing U.S. consumer and producer prices increased more than expected in August. At the same time, oil prices climbed above $100 a barrel as renewed hostilities in the Middle East intensified concerns over global energy supplies.
The combination has forced investors to reassess expectations that inflation would continue to ease without further monetary tightening.
Goldman Sachs said on Friday that it had abandoned its previous forecast for the Fed to leave interest rates unchanged at its September 15-16 meeting. The bank now expects a 25-basis-point increase.
J.P. Morgan has taken an even more hawkish view, forecasting quarter-point rate increases at both the September and December meetings.
"We think that the FOMC will be reluctant to surprise," Goldman Sachs economist David Mericle said.
Inflation Complicates Fed's Path
The latest inflation readings have revived concerns that the long-running decline in price pressures could stall before inflation reaches the Federal Reserve's 2% target.
For much of the past year, investors had expected easing inflation to give policymakers room to lower borrowing costs or at least keep rates steady. The latest figures have complicated that outlook, particularly as energy prices have risen sharply.
J.P. Morgan economists led by Michael Feroli also shifted toward a more aggressive view of monetary policy following the inflation data.
"The week that saw rising bond yields and energy prices and a firm enough set of inflation readings to make a rate hike at next week's FOMC meeting more likely than not," the economists said in a note.
The prospect of higher energy costs is particularly important for the Fed because a sustained increase in oil prices can feed into transportation, manufacturing and consumer prices, potentially keeping inflation elevated for longer.
Markets Raise Rate-Hike Bets
Financial markets have responded rapidly to the changing outlook.
Traders are now pricing in an 87% probability of a quarter-point Fed rate increase this month, up from roughly 70% before the latest inflation reports, according to the CME FedWatch Tool.
Markets are also increasingly anticipating another increase in December.
J.P. Morgan said the latest inflation figures had cast doubt on the durability of the recent disinflation trend. The bank consequently added another rate increase to its forecast for this year and raised its estimate of the long-run federal funds rate to 3.25%.
The shift in expectations has also contributed to higher bond yields, increasing borrowing costs across the U.S. financial system and potentially putting pressure on interest-sensitive sectors of the economy.
Fed Faces Difficult Balancing Act
The Federal Reserve's decision will be closely watched when policymakers conclude their meeting on Wednesday.
Officials must balance two competing risks: allowing inflation to remain above target for too long or tightening monetary policy excessively and weakening economic activity.
The latest data have strengthened the argument for further tightening, but the Fed must also consider the cumulative impact of previous rate increases and the possibility that higher energy prices could temporarily push inflation higher without creating a lasting change in underlying price pressures.
The outlook for monetary policy is likely to remain a major focus for global investors throughout the week, with attention also turning to the Bank of Japan for signals on its own interest-rate policy.
Goldman Still Sees Future Cuts
Despite its more hawkish near-term outlook, Goldman Sachs does not expect the current tightening cycle to continue indefinitely.
In a separate note on Sunday, the bank maintained its forecast for two Fed rate cuts in 2027, although it pushed the expected timing of those reductions further out.
Goldman said it viewed the anticipated rate increase this week as being driven more by market pricing than by a fundamental deterioration in the inflation outlook.
That distinction could prove important for investors. If the Fed raises rates but signals that the move is a precautionary response to temporary inflation pressures rather than the beginning of a prolonged tightening cycle, markets could react very differently than they would to a clear commitment to further increases.
For now, however, the combination of hotter inflation, higher oil prices and rising bond yields has sharply altered expectations for the Fed.
After months in which investors had focused on when the central bank might begin easing policy, the immediate question has shifted to whether policymakers will need to tighten again to keep inflation from regaining momentum.