Can The Economy Grow Without Inflation?

Since the last increase in interest rates by Federal Reserve officials in July, the economy is displaying two trends that central bankers believe may not be sustainable for much longer: increased economic activity and simultaneously reduced inflation.

  • This situation has sparked a debate within the central bank about the extent to which it should adhere to its traditional economic models.
  • It is unlikely that this debate will significantly impact the outcome of the upcoming meeting, where the Fed is expected to maintain steady interest rates to allow more time for assessing the effects of the rapid rate hikes over the past two years.
  • Many observers have noted that the recent sharp rise in long-term interest rates has effectively acted as a substitute for Fed rate hikes, reducing the sense of urgency to make hasty decisions.

However, the ongoing debate could influence future decisions. Officials are likely to keep the possibility of another rate hike in December or later on the table. Their decision will depend on incoming data related to inflation and economic growth, as well as the outcome of their internal debate regarding data interpretation.

Demand And Supply

The widely used models employed by both the Fed and private-sector economists to forecast inflation involve comparing the total demand for goods and services with the total supply, often referred to as "potential output." When demand falls short of potential, it exerts downward pressure on inflation, whereas demand exceeding potential exerts upward pressure on inflation.

  • Most economists believe that the output gap is currently close to zero, if not negative. This is supported by indicators such as the unemployment rate consistently staying below the Fed's estimate of its long-term "natural" rate of 4% for the past 20 months.
  • Additionally, the economy expanded at a seasonally adjusted annual rate of 4.9% in the third quarter, well above the Fed's estimate of the economy's long-term potential growth rate of 1.8%. This suggests that the output gap is rapidly narrowing or may have already closed.

Despite these factors, most measures of inflation have not increased significantly during this period. According to the Fed's conventional model, this divergence cannot continue indefinitely. Either economic growth must slow down, or inflation will start to rise, necessitating further rate hikes. As Fed Governor Christopher Waller put it, "Something's gotta give."

New Models For A New Era?

However, some officials argue that the discrepancy between growth and inflation implies that the conventional model may not be applicable at present.

  • Questioning the validity of conventional models, Chicago Fed President Austan Goolsbee cautioned against basing policy on traditional views.
  • He argued that supply potential has been on the rise as the factors disrupting supply chains during the pandemic have unwound. This, coupled with more stable demand patterns and the Fed's rapid rate increases, has contributed to the recovery in supply and the prevention of the output gap from closing.
  • These skeptical officials would not rush to raise rates solely due to strong demand or employment; they would also require evidence that inflation is no longer declining. Philadelphia Fed President Patrick Harker concurred, emphasizing the importance of sustained inflation for policy decisions.
  • In contrast, officials adhering to the traditional model are concerned about continuously predicting a decline in inflation that never materializes. They believe that inflation can continue to slow down because the public expects the Fed to restore it to 2%, influencing wages and prices accordingly. Allowing an overheated economy to persist, in their view, could lead to higher expected inflation and actual inflation settling at around 3% or higher, exacerbating the recent increase in long-term bond yields.

If economic activity does not decelerate and inflation stops declining, not taking timely action carries the significant risk of undermining the stability of inflation expectations and undoing the progress achieved so far, as expressed by Fed Governor Waller.

The Labor Market Leads The Way

The performance of the labor market in the coming months will be pivotal in settling the debate. If demand is indeed operating well above potential, a tight labor market should lead to inflationary wage increases. Therefore, Fed officials will closely monitor a Labor Department report on compensation growth for the third quarter, which will be released next Tuesday.

  • Despite strong job growth, Fed Chair Jerome Powell has recently indicated less concern about tight labor markets. He pointed out signs of declining wage growth levels that align with the Fed's 2% inflation target over time, diverging from his previous emphasis on a subset of labor-intensive service prices.
  • Powell noted that while the labor market remains tight, it is loosening, reflecting the return to pre-pandemic levels in the share of people quitting jobs for higher pay through job switches and the decreasing ratio of job vacancies to unemployed individuals.
  • One contributing factor to the labor market's loosening, despite robust job growth, is the surge in the number of job seekers due to increased immigration this year.
  • Some Fed officials have also suggested that the natural rate of unemployment is below 4%. New York Fed President John Williams estimated this natural rate to be 3.8%, matching the unemployment rate in September. This implies that the labor market may not currently be overheated.

Powell has previously cautioned against making policy decisions based on unobservable factors such as potential output and the natural rate of unemployment. He recently indicated that these factors continue to influence his perspective on the need for higher interest rates, posing the question of whether the apparent economic strength is a genuine threat to achieving 2% inflation.


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Photo by Jacek Dylag / Unsplash.