The U.S. economy added 288,000 jobs in June, well ahead of most consensus estimates.  Even better, employment gains in April and May were revised upward by about 29,000.  The job gains were widespread across economic sectors, causing the overall unemployment rate to decline from 6.3% to 6.1% in June, a new post-recession low.  Notwithstanding the fact that job growth is not a leading indicator of economic growth (it’s a coincident indicator), one could infer from this data that the U.S. economy is starting to get well back on track.  But could there be a dark side to such good news?

The answer is yes.   It turns out that wages and inflation expectations are significant drivers of future inflation.  Joseph Davis at Vanguard (the mutual fund company) analyzed the factors that most explain the variance in future inflation.  Utilizing data from the U.S. Bureau of Labor Statistics, Federal Reserve, and Bridge/Commodity Research Bureau over the past thirty years, he determined that the above factor influences over 70% of the variation in inflation during this period.  (Other factors include the gap between output and demand, commodity prices, and U.S. dollar exchange rates, although all these factors together contribute less than 30%.)

Inflation expectations are reflected in the link between wages and prices.  As consumers begin to expect higher prices in the future, they tend to bargain for higher wages, which firms are then forced to pass along in the form of price increases.

Fortunately, wage growth has not yet become inflationary.  Despite increasing employment, wage growth has been relatively lackluster.  So far it’s fallen short of the average 4% threshold that historically has indicated a tight labor market.  This is unlike the situation in the late 1970s and early 1980s when wage pressures caused inflation to spike.  Vanguard expects U.S. core inflation to bottom further before rising toward the Federal Reserve’s target of 2% by 2016.

So at the moment we have an improving job situation without an imminent threat of inflation.  That might make bond investors feel more comfortable about extending the duration of their bond portfolios to generate higher yields.  But I would recommend caution.  Remember that it’s the expectation of inflation that can cause interest rates to jump.  We saw this last May (2013) when the Fed announced that they were considering tapering their quantitative easing program.  Even though they stated that the easing wouldn’t begin until at least a year later, interest rates jumped by 0.75% in one week, the biggest short-term spike we’ve seen in a generation!

Regardless, job growth has been particularly stubborn since the depression of 2008.  This latest data represents some good economic news we can all cheer about!