Philadelphia Federal Reserve president Anna Paulson also said this week that she sees a resilient economy that's showing some signs of increased momentum despite tariffs and higher oil prices. She noted that consumer spending has been strong, the AI build-out is driving investment, and the labor market is stable.

She acknowledged that markets are pricing in more interest rate hikes and that the US is on an unsustainable fiscal path.

"I think that the growth numbers have come in in a pretty solid way," she said on the panel in Cleveland. "I think that expectations of continued performance, if you look at earnings and profits for various public companies, they've been coming in above expectations, and there have been signs of resilience that I think the markets are starting to price in."

In a panel on Friday, Cleveland Federal Reserve president Beth Hammack said a number of factors are driving up yields, pointing to a strong economy as a key one.

Top Federal Reserve policymakers view consumer strength as a primary driver. Federal Reserve Chairman Kevin Warsh noted at a recent press conference that economic strength is the primary driver of long-term yields.

The labor market is showing similar resilience. August payrolls jumped by 162,000 , while the unemployment rate held steady at 4.1%. Until this spring, healthcare and social assistance had largely carried the labor market. Since then, hiring has broadened to include a wider range of industries, and over the summer, total job gains averaged a solid 74,000 per month.

This week, a report that generally garners little attention, the S&P's purchasing managers' index, showed the economy could be picking up steam. The report, which measures manufacturing activity, registered its biggest monthly increase since 2022 , while a reading on the service sector jumped to the highest level since 2021, powered by new orders.

"The main reason that bond yields rose sharply is that the US economy is booming," said Ed Yardeni, chief investment strategist of Yardeni Research.

While analysts and economists have pointed to a cocktail of sticky inflation juiced by higher oil prices , demand for AI companies' bonds, and a record $40 trillion federal debt , a debate has emerged about how much of the rise in yields is being driven by a strengthening economy — and how much the economy can take.

This week, the yield on the 10-year Treasury bond — which influences mortgage rates and other borrowing costs — rose to 5.2%, marking its highest level in nearly 20 years .

Higher bond yields, tariffs, and a spike in energy prices haven't been enough to slow the economy down.

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After a slow start to the year, real consumer spending growth accelerated to an annualized rate of 3.4% in the second quarter, and the Atlanta Fed's GDPNow model is currently projecting consumer spending above 4% in the third quarter. Paulson thinks the momentum in consumer spending growth is likely to be boosted by the soaring stock market.

Hammack noted that economic growth has held up reasonably well, and the job market has been right around her estimate of maximum employment.

"We've been expecting the consumer to step back for quite a number of years, and they really haven't," she said. "They've continued to spend, and that's been fueling the economy."

Not everyone agrees growth is the main factor driving up yields. Wil Stith, senior bond portfolio manager at Wilmington Trust, said he believes that growth is part of why bond yields have risen, but that the "major thing" is high government spending and fiscal deficits.

"We and our allies are on a war footing ... The trajectory of fiscal spending is increasing, and there's really no one addressing, well, are we going to correct this, how long is this going to go on for?" Stith said in an interview. "That's the major ingredient as to why we're seeing long yields rise now."

Stith noted, though, that if the economy were contracting, bond yields would be lower.

Where do yields go from here?

Stith thinks the yield on the 10-year Treasury, currently around 5.2%, could top out at 5.5%. If the yield starts climbing above that level, then the Fed would likely increase rates more, causing more pain for the economy and a sell-off in stocks, which have helped drive consumer spending.

Read more: How soaring Treasury yields could hit your finances

So far, Yardeni said the yield on the 10-year Treasury remains below the growth rate of nominal GDP, which was 6.6% in the second quarter and will likely be even higher in the third quarter. In the past, especially during the 1980s, the so-called bond vigilantes pushed the bond yield above nominal GDP to slow the economy.

"They haven't done that so far," he said. "The risk is that they will do that if the Fed fails to subdue inflation."

Yardeni said he expects the 10-year bond yield to settle in the 4.00%-5.00% range this year, mirroring the range during the five years before the 2008 financial crisis. "Nevertheless, the risks now clearly point to more upside in yields," he said.

For yields to fall, a resolution of the war in the Middle East that would lower oil prices is likely needed. Another possibility, Yardeni said, is that Treasury Secretary Scott Bessent will act to bring bond yields down by buying back more Treasury bonds and issuing more Treasury bills.

The Fed's next moves

Faced with growth and sticky inflation from global conflicts involving Iran, Russia, and Ukraine, the Federal Reserve has abandoned its earlier hopes for rate cuts. Following a rate hike in September, Wall Street is now preparing for more rate hikes.

Markets are now pricing in a 66% chance the Fed hikes again in October and a 52% chance they hike again in December.

Hammack suggested the Fed needs to raise rates further.

"We're in an environment right now where I don't see our policy stance as restraining investment in the economy," she said.

She noted that when she speaks with businesses about making new investments, interest rates are not a factor for most, outside of the housing sector.

"So they're continuing to invest in the economy, which is good. We like that from a growth perspective," she said. "But if it's creating more inflationary pressures, that's something we need to be mindful of and make sure we bring that back under control."

Stith said if the economic data continues to come in strong, both on growth and jobs, and if inflation is higher than expected, the Fed will raise rates again in October and December. He doesn't think a quarter percentage point increase is enough to bring down inflation, and another quarter point probably isn't either. He thinks the Fed is more likely looking at 100 basis points of rate hikes.

And yet, if borrowing costs continue to climb, that may not slow down the economy the way it has in the past.

Pershing Square CEO Bill Ackman posted on X, "What if higher rates don't reduce demand and investment because the demand for intelligence and energy is unaffected by higher rates because winning the race for super intelligence has a near infinite ROI and the demand for compute will remain incalculable."

"What if the old models don't apply to the current paradigm and the Fed is wrong?" he continued.

In that light, he said he thinks the Fed might have made a mistake in raising rates.

Jennifer Schonberger is a veteran financial journalist covering markets, the economy, and investing. At Yahoo Finance, she covers the Federal Reserve, Congress, the White House, the Treasury, the SEC, the economy, cryptocurrencies, and the intersection of Washington policy with finance. Follow her on X @Jenniferisms and on Instagram.

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