Inflation Stays Reassuringly High (For Government)

Governments like inflation when it's high enough to erode the public debt without causing a revolt.

Will people catch on to the inflation scam?

Yesterday's CPI figures came in slightly hot, with headline inflation at 3.1% rather than the expected 2.9%. While it's a whole lot better than it was back in 2022, when inflation was running at 9%, it's still far above the Fed's target of 2%.

Five-year inflation chart, BLS
Inflation is down to manageable levels at last.

But it turns out that, at least for the government, that might be a good thing.

Love/Hate Relationship

Governments have a love/hate relationship with inflation. On the one hand, high inflation causes citizens pain and makes it look like the government isn't managing the economy well. On the other, inflation eats away at the real-terms value of debt. If you borrow $1 million and the value of a dollar falls by 50%, you only have to pay back the equivalent of $500,000.

When you're borrowing large amounts of money, that seems like a good deal. When your debt hits unsustainable levels—say, $34 trillion, with $52 trillion forecast by 2033—then higher inflation isn't just desirable. It's essential.

Jay Powell: US Debt Is “Unsustainable”
Even the Federal Reserve Chair is sounding alarm bells about the size and unsustainability of the national debt.

Inflation, Tax, Or Default

For governments, there are only three ways to reduce unsustainable debt ("unsustainable" here meaning "growing faster than the economy"). Collect more money in the form of taxes, decrease the real-terms value of the debt by debasing the currency, or default.

None of these are good options.

Inflation is the least-worst choice. Central banks generally target 2% inflation for a number of reasons:

  • There's a psychological effect where people feel richer if their earnings are rising.
  • It gives them some wiggle room in avoiding deflation, which can be a far greater problem.
  • It reduces the size of the public debt in real terms.

But 2% just isn't enough when the debt is as large as it currently is. On the other hand, when inflation is too high, say above 5%, people really start to notice. Central banks have to raise interest rates, slowing the economy down and impacting markets. Not ideal.

In between, there's a sweet spot for the government. This "Goldilocks" zone is high enough to gradually chip away at the debt, and it's high enough to be painful for consumers, but not so high that drastic action is needed, or that people start taking to the streets with pitchforks.

It's very likely that 3-4% could be the new normal for inflation.

What, did you think "higher for longer" was just reserved for interest rates?

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