The Fed is debating whether inflation will be driven by wages or low unemployment.

Inflation has been stubbornly high for some time, but it is finally beginning to ease as supply chain disruptions fade and interest rates rise. However, Federal Reserve officials are now expressing concern that prices could begin to rise again because labor markets are so tight.

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The question is how to best forecast inflation: should more weight be given to recent readings on prices and wages that are influenced by the pandemic, or should a traditional top-down analysis be used that looks at how far the economy is operating above or below its normal capacity? There is disagreement within the Federal Reserve about which inflation metric is more important, with some arguing that the Personal Consumption Expenditures (PCE) index is more relevant and that this could argue for tighter monetary policy for longer. Others believe that the Consumer Price Index (CPI) is more important, which could lead to a milder approach.

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The Federal Reserve is expected to raise interest rates by a quarter percentage point on Wednesday, slowing the pace of increases for the second consecutive meeting. This would give officials more time to study the effects of earlier rate rises. They are likely to debate how long to continue raising rates and how long to hold them at that higher level.

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The models that economists use to predict inflation compare the country's total demand for goods and services with their total supply as represented by the "output gap" - the difference between actual gross domestic product and potential GDP based on available capital and labor. They also use the Phillips curve, which predicts that wages and prices will rise when unemployment falls below a certain level.

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It is difficult to estimate these variables even in normal times, let alone after a pandemic and amid the war in Ukraine. The natural unemployment rate can only be inferred from the behavior of prices and wages. A decade ago, Fed officials put it between 5% and 6%. However, they revised it lower to around 4% as actual unemployment fell below 4% without much acceleration in wages.

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Aneta Markowska, chief economist at Jefferies LLC, said that their projections for interest rates and inflation in December suggest that they think the natural rate has temporarily shifted up to around 4.8%. With unemployment now at 3.5%, that suggests the labor market is too tight and likely to keep wage pressure high.
At last month's Fed meeting, minutes show that central bank staff economists think the natural rate might decline slowly due to inefficient job-matching, suggesting that price pressures could persist for longer than previously thought.

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The staff also revised down estimates of potential output because of tepid labor force growth, leaving actual output even further above its sustainable level. Staff saw this output gap persisting until the end of 2024, a year longer than they projected just a few weeks earlier. This means that the economy will continue to operate above its potential for the next few years, which could lead to inflationary pressures.

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"This is a significant move," said Riccardo Trezzi, a former Fed economist who now runs an economic-consulting firm in Geneva. "The staff is telling the committee that they cannot give up now, because if they do, inflation will remain significantly above 2% in the medium term." Despite this, Fed officials are still cautious about relying too heavily on output gaps and Phillips curves. Since an overheated labor market is likely to manifest itself first in wages, many officials see those as a better indicator of underlying inflationary pressure. Wages reveal what employers think they can recover via prices or productivity, and what workers expect given their own cost of living.

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If wages continue to grow at their current rate, inflation will remain well above the Federal Reserve's 2% inflation goal. This is assuming that productivity grows at a rate of 1% to 1.5% per year.

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This is why Fed policy makers revised their projections for inflation upwards last month. Higher wage growth boosts aggregate incomes, providing spending power that can sustain higher prices. Officials worry that tight labor markets could allow paychecks to rise in lockstep with prices, as occurred during the 1970s. Since last month's meeting, there has been more evidence that labor demand may have softened, including declines in temporary hiring and hours worked. If wage growth slipped to 4%, getting inflation to 2% would be easier. This could mean that the Fed may need to take more aggressive actions in order to reach their inflation target.

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An increase in the number of workers would help to reduce concerns about wages. Jonathan Pingle, chief U.S. economist at UBS, believes that labor shortages could ease as immigration rebounds. Last month, the Census Bureau published estimates showing that net immigration for the 12 months through June topped 1 million for the first time since 2017.

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Fed officials closely monitor the employment-cost index, as it is the most comprehensive measure of wage growth. The fourth-quarter figure is set to be released on Tuesday.

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Inflation, as measured by the 12-month change in the price index of personal-consumption expenditures excluding food and energy, fell to 4.4% last month from 5.2% in September. Though it is still above the Fed's 2% goal, it moderated in the last three months to an annualized 2.9%. Inflation is slowing because prices of goods are falling. Large increases in housing costs have slowed but haven’t filtered through to official price gauges yet. As a result, Fed Chair Jerome Powell and several colleagues shifted attention recently toward a narrower subset of labor-intensive services. These services exclude prices for food, energy, shelter and goods.

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According to Mr. Powell, prices in the category that rose 4% in December from the previous year offer the best gauge of how higher wage costs are being passed on to consumers. In a speech this month, Fed Vice Chair Lael Brainard offered a more optimistic reassessment of the view that wages and prices for non-housing service prices are linked. She highlighted reasons why the links between these two factors might be weaker than previously thought.

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She pointed to the prospect for prices to moderate if they reflect the ripple effects of recent global dislocations that are now reversing. Prices of restaurant meals, car insurance and airfares, for example, could ease if they have been primarily caused by the pass-through of higher food prices, car prices, and fuel prices, respectively.
According to Mr. Pingle of UBS, if wage pressures are moderating on their own, it becomes harder to tell a story where you’re going to be really worried about a wage-price spiral developing.

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John Roberts, who used to work as an economist for the Federal Reserve, believes that there is potential for non-wage costs to go down and relieve some pressure on services inflation. However, he thinks that in the long run, if wage growth stays as high as it is currently, inflation will still be an issue.