Does stronger wage growth mean it’s time to hike interest rates?

Late last week the U.S. Bureau of Labor Statistics released the latest data from the Employment Cost Index, providing policymakers with new insight into shifts in the U.S. labor market since the last update three months ago. According to the Employment Cost Index, real wage growth (after accounting for inflation) is now at levels posted before the start of the Great Recession in December, 2007. This is good news for workers, especially those already employed. But is this wage growth sustainable?

The Employment Cost Index shows that total compensation for all U.S. workers increased by 2.3 percent from June 2015 to June 2016. Wages and salaries grew at a 2.6 percent clip, continuing a recent trend of wage growth outpacing overall compensation growth. These figures are in nominal terms, however, which means that after accounting for changes in prices, real wage growth increased by 1.3 percent over the past year.

The Employment Cost Index is a useful measure of wage growth compared to the average hourly earnings measure from the monthly Employment Situation report because the index measures the shifting composition of the U.S. workforce when calculating wage growth. This makes it a better measure of the amount of slack in the labor market. Strong wage growth is a sign that labor market slack is diminishing and that the labor market is tight.

For now, at least, workers are seeing real gains. But this is primarily due to the low levels of inflation in recent years as nominal wage growth continues to be below pre-recession levels. If employers’ inflation expectations ratchet down to our current lower levels of inflation, then nominal wage growth might decline as well. The result would be weaker real wage growth. Which brings policymakers back to the question: Is slack gone from the labor market?

Accelerating wage growth evident in the recent Employment Cost Index data indicates that slack is indeed on the decline. At the same time, the Federal Reserve Bank of Atlanta’s Wage Growth Tracker shows very strong wage growth for workers who are already employed.

Is this a sign that the Federal Reserve Board should be ready to hike interest rates? Given that inflation could use a bit of a boost to hit the Fed’s 2-percent target, and that monetary policymakers might want to overshoot for once, such a wage-led inflationary pressure might be welcome. What’s more, recent evidence shows that U.S. wage growth doesn’t seem to lead to inflation as much as it did in the past. Stronger wage growth going forward could help shift income toward hourly and salaried workers—not such a terrible outcome for increasing demand in the U.S. economy and thus overall economic growth.