The political upheaval in Libya has pushed oil prices to a 28-month high. Whenever crude runs skyward, fears of higher inflation usually follow, and this time is no different.

But one closely watched measure of inflation expectations in the U.S. is holding steady. The yield spread on the conventional 10-year Treasury less its inflation-indexed counterpart remains in the 2%-to-2.5% range that’s prevailed for months.
Higher oil and commodity prices could elevate inflation, of course. It’s happened before. “The 68 percent increase in the price of oil in 1974 was an adverse supply shock of major proportions,” writes economist Greg Mankiw in Macroeconomics. “As one would have expected, it led to both higher inflation and higher unemployment.” But that was then. The Treasury market these days seems to be saying that the inflationary effect of rising oil prices will be mild. What’s different in 2011? The blowback from the Great Recession, of course. But there are opposing forces too. The Fed’s exit strategy for unwinding zero interest rates may stoke inflation down the road–if the monetary adjustment is executed poorly. But none of this seems to be worrying the Treasury market, at least at the moment.

Some analysts argue that inflation is driven by the trend in wages, which remains tame, as one commentator tells Bloomberg:

“U.S. inflation runs on wages, period,” and workers pay and benefits have declined, Brian Belski, chief investment strategist in New York for Oppenheimer & Co., said in a telephone interview. “Until we start to see expansive and robust job growth we are still several quarters away from any kind of semblance of wage inflation. Yields on the 10-year note will settle somewhere south of 4 percent.”

The latest data on wages suggest that inflationary pressures are minimal. For example, the Labor Department’s index of weekly hours worked in the private sector fell last month for the first time in a year.

Meanwhile, the trend in average hourly earnings still looks subdued too. As the chart below shows, the 12-month percentage change in earnings remains under 2.5%, the lowest pace in years.

The recovery in the labor market, in other words, remains sluggish, and that’s helping keep a lid on inflationary pressures. Last month’s net gain in private industry nonfarm payrolls was a paltry 50,000—the lowest since May 2010.

Some economists blame the harsh winter weather for January’s weakness, but warmer days are coming. The crowd expects a rebound in the February jobs report (scheduled for release on March 4). The consensus forecast calls for a gain 185,000 private nonfarm jobs in next week’s update, according to Briefing.com.
If job growth strengthens, will that change the bond market’s expectations on inflation? Perhaps the answer depends on the price of oil that day.