Since Federal Reserve officials last raised interest rates in July, the economy is doing two things that central bankers don’t think it can sustain much longer: revving up activity and at the same time slowing inflation.

It has set off a debate within the central bank about how closely it should follow its traditional models of the economy. The debate is unlikely to affect the outcome of its meeting next week, when the Fed is set to hold interest rates steady to provide more time to see the effects of their rapid increases over the past two years. 

Many see the swift rise in long-term interest rates over the past month as having effectively substituted for Fed rate rises, which also has reduced the urgency to rush to judgment.

But the debate could affect what happens next. Officials are likely to keep the door open to another hike in December or beyond. Whether they walk through that door depends on incoming data on inflation and growth—and the outcome of their internal debate over how to interpret that data.

The workhorse models that Fed and private-sector economists use to forecast inflation compare total demand for goods and services with the total supply, called “potential output.” When demand is below potential, the resulting output gap places downward pressure on inflation. When demand is above potential, that negative output gap puts upward pressure on inflation.

Most economists believe the output gap is currently close to zero, if not negative. One bit of evidence: The unemployment rate has been below Fed officials’ estimate of its long-run “natural” rate of 4% for 20 months. Another: The economy grew at a 4.9% seasonally adjusted annual rate during the third quarter, the Commerce Department said this past week. That is well above officials’ estimate of the economy’s long-run potential growth rate of 1.8%, meaning the gap is rapidly closing if it hasn’t closed already.

And yet most measures of inflation have eased in that time. Under the Fed’s conventional model, that divergence can’t continue. Either growth has to slow or inflation will start to rise, requiring more rate rises. “Something’s gotta give,” said Fed governor Christopher Waller in a recent speech.

But other officials think the divergence between growth and inflation shows the conventional model shouldn’t be used right now.

 Questioning the conventional models

“We need to be extra careful about indexing policy to this traditional view,” said Chicago Fed President Austan Goolsbee in a speech last month. Though dry and technical, it represented a bold challenge to received wisdom inside the central bank.

The economy’s supply potential was depressed when the pandemic screwed up supply chains and interfered with the matching of open jobs with would-be workers. As those factors have unwound, potential is rising briskly—preventing the output gap from closing, he suggested.

The recovery in supply has been helped by demand slowing to more stable patterns and by the Fed’s rapid rate increases, which are preventing expectations of future inflation from rising, Goolsbee said.  

“Holding to the simple historical correlations of what growth and labor market conditions mean for inflation in the face of positive supply developments is a recipe for overshooting and causing an unnecessary downturn,” he said. 

These skeptical officials wouldn’t raise rates again solely because of briskly growing demand or employment; they would also want evidence that inflation has stopped going down. “If inflation were moving up in a sustained way, then I would behave very differently than if I saw just continued strength in, say, retail sales for another month or so,” said Philadelphia Fed President Patrick Harker in a recent interview.

By contrast, officials who are sticking with the traditional model worry about continuing to forecast a decline in inflation that doesn’t materialize. They believe inflation can continue to slow because the public expects the Fed to return it to 2% and will set wages and prices accordingly. 

If the Fed sought to exploit this by allowing an overheated economy to persist, expected inflation could rise and actual inflation could settle around 3% or higher, exacerbating the recent rise in long-term bond yields.  

If economic activity doesn’t slow and inflation stops declining, “failing to take action in a timely way carries the considerable risk of undermining what have been fairly stable inflation expectations and possibly unwinding the work that we have done to date,” Waller said in his speech.

Is strength generating heat?

The performance of the labor market in the months ahead will be especially important in settling the debate. If demand really is operating dangerously above potential, a tight labor market should be generating inflationary wage gains. That is why Fed officials will closely watch a Labor Department report next Tuesday on compensation growth for the third quarter.

Payrolls have grown 266,000, on average, in the last three months, more than double what’s considered consistent with population growth. Yet Fed Chair Jerome Powell has recently signaled less concern about tight labor markets. 

In a notable shift, Powell in a speech this month said recent indicators of wage growth have shown signs of declining to levels that would be consistent with the Fed’s 2% inflation goal over time. He didn’t draw attention, as he has over the past year, to a subset of labor-intensive service prices that exclude energy, food, and shelter.

“It’s still a very tight labor market, but it’s loosening,” said Powell, who as recently as January referred to the labor market as “out of balance.”

The share of people quitting jobs—often commanding higher pay by switching jobs—has moved back to prepandemic levels, and the ratio of job vacancies for every unemployed person has been falling. One reason the labor market is loosening despite still robust job growth is that the number of people looking for jobs has surged this year amid a rebound in immigration.

Some Fed officials have also concluded that the natural rate of unemployment is below 4%. New York Fed President John Williams said last month he estimates this so-called natural rate of unemployment is 3.8%, which equaled the unemployment rate in September. That would imply the labor market isn’t necessarily overheated now.

Powell has in the past warned about basing policy on unobservable factors such as potential output and the natural rate of unemployment. He recently signaled that those things continue to weigh on how he sees the need for higher rates. “Is the heat that we see in GDP really a threat to our ability to get back to 2% inflation?” Powell said. “That’s going to be the question.”