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Behind Janet Yellen's inflation dilemma

In 1996, Fed Chairman Alan Greenspan made a bold and still unsung call. With labor markets tight, unemployment low and inflation concerns simmering, he resisted pressure to hike interest rates because he felt that the incipient technological revolution would keep a lid on prices.

Arguing against him during that time was a Fed governor only in her second year on the board. Janet Yellen, transcripts of the Fed meeting from that year show, was concerned that the economy was "operating in an inflationary danger zone."

Fast forward to 2014 where Yellen now as Fed chair will face her own challenge to make a bold call and either resist or go along with conventional wisdom and hold the line on interest rates.

Janet Yellen, chair of the Federal Reserve, speaks at The Economic Club of New York on April 16, 2014.
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Janet Yellen, chair of the Federal Reserve, speaks at The Economic Club of New York on April 16, 2014.

Once again, the pressing issue is labor markets and the possibility that they could ignite inflation in the U.S. economy. Increasingly, there are concerns that, despite high unemployment, the jobs market may actually be tighter than it appears. And any whiff of a rise in wages prompts almost panic-level pronouncements in bond markets that inflation will reignite.

A chart from Deutsche Bank's chief international economist, Torsten Slok, on Tuesday was headlined: "Wage Inflation Now Above Pre-Crisis Levels." It noted that median weekly wage gains at around 3 percent year over year had for the first time since the end of the recession topped the pre-crisis average. "It should be obvious to everyone by now that there is wage pressure in the pipeline and that the Fed will turn more hawkish later this year," Slok said.

Yellen appears to be trying to resist what is so obvious to Slok and others. So far, she has indicated a willingness to accept stronger wage gains. And she has not embraced a theory from Alan Krueger, the former head of the Council of Economic Advisors, a position Yellen once held, that there may be considerably less slack in the labor market than some believe.

Read More Jobless rate still good gauge of slack: Fed study

With Fed interest rates at zero and its balance sheet now topping $4 trillion, there is no more significant issue in economics today than whether tight labor markets will lead us into and beyond the inflationary danger zone. The worry is that the Fed has put so much fuel into the economy that any spark could ignite an inflation firestorm.

At her first press conference in March, Yellen gave her first indication of her views on the issue. "Most measures of wage increase are running at very low levels," she said.

Yellen went on to provide insight into her thinking on how high is too high for wages. "In fact, with the productivity growth we have and 2 percent inflation, one would probably expect to see, on an ongoing basis, something between—perhaps 3 and 4 percent wage inflation would be normal."

Average hourly earnings are about 2.1 percent annually, compared with 3.4 percent in the year before the recession. Factoring in inflation, wages have risen just a half point in the past year. That measure is well below the productivity gains of 1.3 percent, so workers continue not to be compensated for their growing efficiency. Put another way, wages are not rising anywhere near the level of inflation plus productivity.

Even if wage growth sparked some inflation, Yellen would have reason not to panic. In fact, the Fed wants some inflation, says economist Jared Bernstein. It's preferred inflation measure, the price index of personal consumption expenditures, is running just 0.9 percent over the year-ago level. The Fed wants 2 percent inflation. So at least a touch of wage-induced inflation would appear to be welcome by the Fed.

Read More Economists expect US to shake off winter slowdown

But Deutsche's Slok worries about such a development. He said if the Fed stays at zero interest rates with a large balance sheet, and wages tick up to even the desired 3 percent to 4 percent level, that the Fed will be substantially behind the curve if wages or inflation rise any higher.

"For monetary policy to hold wages down, you need to be above the neutral rate," Slok said. "If you wait until wage inflation is 3.5 percent and then she says now we need to do something, it's already too late."

Jim O'Sullivan, chief U.S. economist from High Frequency Economics, argued that the still-large Fed balance sheet "will continue to provide net stimulus for years." That will further complicate Yellen's ability to rein in wage-induced inflation, should it come.

Yellen's choice is further complicated by an argument from someone who should be more ideologically sympathetic: Princeton economist Krueger. A recent paper by Krueger has become the flash point for debate over Fed policy because it relates directly to the issue of potential wage inflation.

Krueger argues that the long-term unemployed, of which there are 3.7 million, are unlikely to come back into the workforce. As a result, his argument goes, they do not exercise downward pressure on wages. His work has prompted some to take out this group when trying to gauge actual labor slack in the economy by looking at the unemployment rate.

The result: the unemployment rate for the short-term unemployed is about back to where it was before the recession. The conclusion (although this is not necessarily Krueger's) is that workers will soon have the ability to negotiate higher wage gains that could cause inflation.

Asked about the theory surrounding Krueger's work at a recent speech, Yellen said, politely, "it is conceivable."

But she went on to counter it: "I think it's premature, frankly, to jump to the conclusion that that argument is correct. And I've made some arguments in other remarks that I've given about why I think that the long-term unemployed are likely to move back more actively into the labor force and into the job market and exert pressure on wages and prices as the labor markets strengthened."

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Yellen has also pointed out that 7 million Americans are working part time for economic reasons. By increasing their hours, they could provide substantial more labor to the economy. Those available hours, theoretically, should put downward pressure on wages.

None of this suggests Yellen will remain at zero indefinitely. She has already indicated a willingness to change policy in line with incoming data and not pre-commit the Fed to specific indicators or time markers. It does suggest, however, that Yellen will be slower to pull the trigger in the face of either higher inflation or more robust wage gains than some on Wall Street and even in the inner circles of monetary policy would like.

This puts Yellen very much in the same seat Greenspan occupied in 1996. She needs to make a call about the economy for which neither the evidence nor the correct path is entirely clear. She will be forced to weigh the arguments and the data and come to a conclusion and, like Greenspan did, take on some powerful players in the process. That makes the coming debate over inflation and monetary policy not just a test of dueling models and economic theories, but also one of of character and leadership.

She will know that back in 1996, when Greenspan held the line on rates, most agree he ended up being right.

—By CNBC's Steve Liesman.

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