More promising data came out this week. Inflation is coming down, but much quicker than most commentators realize, and this began much earlier too. 

As we have observed and asserted over the last few months, the measure of inflation that has so frightened consumers into frugality exaggerates true price increases. By looking at the change in prices compared to the same time in the previous year, we continue to relive like Groundhog Day the same huge runup in prices late last year as the economy went into hyperbuy mode following the worst of COVID, and big energy price runups early in 2023 because of profiteering in the energy sector following Russia’s invasion of Ukraine. 

The inflation rate measures the result of forces that drive prices higher. These two effects of aggregate demand on steroids arising from way too much fiscal policy and way too short supply, and then energy crunch have now stabilized, and may even be reverting back to the mean. If we continue to look at inflation twelve months at a time, it will still be a few months more before this unfortunate past no longer influences our future. 

Instead, we can look at price rises over one month, three months, or six months, and “annualize” them by, roughly, multiplying the one month rise in prices by twelve, the three month rise by four and the semi-annual rise by two. The math is a little bit more complicated than that, and it accurately reflected in the graph of the week, but you get it. 

While the media and commentators are still talking about an annual inflation rate of around 7%, the more accurate rate based on the more relevant shorter periods, the annualized inflation rate is in a tight range right around 2%, just where we want it to be. 

Of course, it has been a painful process to get to this point. In flying we refer to pilot-induced oscillations. They arise when a pilot reacts to rather than anticipates the forces affecting the flight path. A first year student in macroeconomics should be able to predict that the huge spending post COVID, sponsored, thank you, by the U.S. government, will induce demand pull inflation. The equally intense energy price runup a few months later will add to this some cost push inflation, followed by wage push inflation. Both phenomena were easy to anticipate, and there are solutions to avoid these effects.

Of course, politics often gets in the way of good economics. It is also widely understood now that the Fed too was politicized into delaying responses until it was too late. Their response now is setting the appropriate tone, but at a much higher cost than necessary. A stitch in time would have saved nine (percent inflation). 

Inflation that is permitted to run away becomes institutionalized, though. It causes entities to artificially change strategies and priorities. Obviously, any departure from optimal long term strategies that are efficient and equitable in the long run can only cause inefficiencies. These inefficiencies are in the form of unnecessary inflation or unemployment, depending on the direction of the macroeconomic errors. 

Unfortunately, inflation has spread. We must now try to coordinate macroeconomic policy across major nations when it is apparent we cannot even coordinate fiscal and monetary policy within our nation. Not only have public pension funds bet wrong, but the fragile crypto market has come crashing down. In addition, in times of uncertainty, there is a flight toward US bonds and hence a strengthening of the U.S. dollar. Nations and big banks with been engaging in off-the-books foreign exchange swaps. A central bank might give up some Canadian dollars now for some U.S. dollars, with the promise to exchange the same U.S. dollars later for return of the Canadian dollars. I call them off-the-books because they aren’t loans. They are just temporary changes in the composition of assets, to revert back later. 

This way, large financial institutions are making bets on the direction of foreign exchange rates, to the tune of tens of trillions of dollars, far larger than any other bets being made internationally these days, but, due to a quirk in accounting, go essentially unreported. Changes in inflation or interest rates can cause huge imbalances in wealth when it comes time to reverse their transactions. 

Such swaps are partly the pursuit of profits in financial markets that have yielded far too little after more than a dozen years of interest rates held down to ridiculously low levels by central banks. 

As U.S. interest rates accelerate because of the Fed’s too-little-too-late policies, those who borrow in U.S. dollars, including the biggest borrower of them all, the U.S. government, now find themselves paying much higher than anticipated interest payments. This is one reason why the U.S. government will continue to run budget deficits. We have been borrowing to the tune of $15 trillion over the past decade and a half under the belief that it was cheap money. It’s kinda like the teaser rate your credit card company offers - borrow now at 0% (plus a transaction fee) for a year, but, in fine print, if you don’t pay the money back in a year, you pay the customary 21.9%. Ouch. 

Now, with the Fed no longer acting as the lender of last resort at low interest rates, there is nobody to bail us out. It’s like tough love from the parents - the children will have to pay for their own mistakes now. 

Double ouch. 

The good news is that the U.S. is not at all alone in this dysfunction. That’s the bad news too. This malady is global, with no nation having the capacity to bail themselves out, much less anybody else. With globalized trade and multinational companies and finances, even if we can cure the economic virus in one country, it does little good unless we clear the virus everywhere. American loose monetary policy for far too long has spread, and that will be far harder to cure than our own inflation, which by all appearances has been on the mend.