Wage growth is “not a threat to inflation,” Fed Chair Janet Yellen said on June 18. “[With] our 2 percent inflation objective, we could see wages growing at a more rapid rate” before having to worry.

“When unemployment goes into the five range, that is going to below the natural rate,” St. Louis Fed President James Bullard said on July 9. “I think we are going to overshoot here on inflation.”

Who is right?

In today’s Geo-Graphic, we look at the relationship between wage growth and inflation over the last twenty years. Perhaps surprisingly, we find virtually none (an R-Squared of 0.03). Wage growth has routinely exceeded so-called core inflation (consumer goods inflation excluding energy and food) by large amounts without the latter picking up. One explanation for this phenomenon may be the growth of imports as a percentage of GDP, from 9% in 1994 to 16% today, which acts to keep tradeables prices down. This supports Yellen’s position.

This does not mean, however, that wage growth should not concern the Fed. On the contrary, as we can see from the figure on the left, unusually high wage growth—above 4%—preceded the last two recessions, in 2001 and 2007. The explanation may lie in the fact that high wage growth induces people to assume more debt that they would otherwise. Rapid wage growth was associated with rising debt service burdens during both periods, as shown in the figure on the right. Increasing debt service payments tend to crowd out other forms of consumer spending, and make households more vulnerable if expected wage increases fail to materialize.

Annualized wage growth at present is still moderate, running at about 2.3%. But it is clearly on the rise. The household debt service ratio, however, is at its lowest level since the series began in 1980, and household debt is less than it was in Q1 2008—though it has started moving up again.

In short, the monetary history of the past twenty years suggests that wage growth at current or moderately higher levels is unlikely to cause a significant rise in consumer price inflation. Yet a continued trending up in wage growth would likely presage a rise in household leverage, which is a credible indicator of economic instability ahead. But at the current low leverage levels, far ahead.

The Economist: Waiting for Inflation

Wall Street Journal: America Inc. Wakes Up to Wage Inflation

VoxEU: The Impact of Low-Income Economies on U.S. Inflation

Financial Times: Fed Bond Buying Set to End in October

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Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”