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U.S. Federal Reserve Chair Janet Yellen.

John Gress/Reuters

After the U.S. inflation rate jumped higher than expected last week, the world was suddenly awash with concern that the Federal Reserve was going to have to raise its key interest rate sooner than expected or run the risk of allowing inflation to bubble up to uncomfortable levels.

But here comes the other side of the argument, which boils down to a key observation: Wages are going nowhere, and without increases there it's hard to see the uptick in the consumer price index as anything more than a blip.

Even though the unemployment rate has fallen to a five-year low of 6.3 per cent, Tim Duy, an economics professor at the University of Oregon, pointed out that there is a lot of slack in the labour market; wage growth is "restrained."

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"In short, you shouldn't be looking at the inflation numbers without understanding the underlying wage dynamic," Mr. Duy said in a blog post. "It isn't until wages start to push higher that inflation becomes a more interesting issue."

Writing on his New York Times blog, Paul Krugman agreed: "A modest uptick in core inflation has all the usual suspects declaring that the Fed will/must tighten now now now. Meanwhile, Janet Yellen is looking at wages, which are going nowhere, and sitting tight."

For all the flutter on Wall Street, the bond market appears to agree with this assessment. The yield on the 10-year Treasury bond, which is sensitive to inflation and interest-rate expectations, is 2.6 per cent. That is not quite midway between its 3 per cent high at the start of the year and its 2.44 per cent low in May. The yield has been steady throughout most of June.

Still, the debate over inflation certainly heated up last week after the U.S. Labor Department reported that CPI in May rose to 2.1 per cent year-over-year, up from 2 per cent in April. After accounting for volatile food and energy items, the core rate was 2 per cent, up from 1.8 per cent in April – in line with the Fed's objective but clearly at risk of rising above it.

Fed chair Janet Yellen didn't sound too concerned in her comments last week, arguing that rising CPI figures could be nothing more than "noise."

The stock market took that to mean that the Fed is going to keep its key interest rate near zero and dismiss early signs of inflation – a dovish response that drove the S&P 500 to new highs last week.

But this interpretation isn't quite right: Yes, the Fed is going to keep its rate low, likely for another year, but ignoring inflation isn't a factor.

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Mr. Duy explains: "They anticipate that wage growth will not emerge more forcefully until after underemployment measures fall to more normal levels. Hence as the measures approach normal levels – some time next year – they will begin raising interest rates. I suspect this will be prior to a substantial acceleration in wage growth, on the assumption that they will feel a need to be somewhat ahead of the curve."

In other words, tighter monetary policy is coming. But don't blame inflation just yet.

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