An Economist Looks at Inflation

[youbet]

Historically, interest rates have to go higher than inflation in order to bring inflation down..

Which interest rates specifically?

 

[daylatedollarshort]

SS and TIPS are supposed to match inflation, and then you usually pay taxes on your gains. That's quite different from simply having enough money that inflation is not a problem for you, or using certain investment to cover your "must have" expenses and using riskier investments for you "fun" expsnses.

I still don't see how any of the strategies listed in the boggleheads link will allow you consistently to come out ahead of inflation, after taxes. Their merit seems to be in preventing going broke, a good idea but not the same thing.

I have TIPS in retirement accounts so I have to pay taxes on them anyway. The ones we own all have real yields, not 0% like current I-bonds. I'm not going to post my exact numbers but I will post some examples of how one can come out ahead with high inflation. In our case we have a low fixed interest mortgage and our property taxes don't go up much because of Prop 13 annual caps. That leaves our other expenses, which we try to continually optimize, so our personal inflation rate tends to go down, not up, over time.

If you have a 3% rate, $300K mortgage and have the money invested in 2% TIPS making 10% with 8% inflation, that is an extra $21K a year on the difference ((10 - 3) * $300K). The mortgage is fixed so the higher inflation goes, the more one makes on the difference. IN another scenario, if you have $1M in 2% real yield TIPS and $50K in annual SS benefits, and $50K in inflation adjusted annual expenses, and inflation runs 9%, then SS COLA increases should cover your inflation expense increases and you have $110K in TIPS income leftover, 8% to match inflation and a 2% real yield.

Low expenses subject to inflation, low fixed rate mortgage, TIPS / I bonds with real returns, SS, COLA pensions, real estate and other assets, rental income - I would think there are many scenarios where people could come out ahead with high inflation. Even better if they have low overhead and their personal inflation rates went down every year instead of up.

 

[daylatedollarshort]

Which interest rates specifically?

In the U.S. it would be The Fed raising the federal funds rates which usually impacts other rates, like mortgage rates and Treasury yields: "A cardinal principle of optimal policy in a situation of above-target inflation is to raise nominal rates by more than the change in expected inflation – the Taylor principle. If real short-term interest rates fail to increase, monetary policy will be ineffective in dealing with high inflation." - Monetary policy and the Great Volatility (europa.eu)


ETA: "In the past, addressing an inflation problem necessitated the Fed raising interest rates above the inflation rate. Even using the Fed’s preferred inflation measure, which is now tracking at 6.4 percent, that would mean rates far higher than the Fed’s current prediction of 2.4 to 3.1 percent by the end of 2023." - https://www.nytimes.com/2022/04/14/opinion/interest-rates-inflation-federal-reserve.html

 

[HarryHawk]

Of course the other thing that comes into play with regards to raising interest rates is who owes more money than the Federal government? Not so bad when you can be paying inflated dollars to cover your debt. Covering those interest payments at .05% gets a whole lot more interesting when the rates skyrocket to 4% and who knows how much higher.

 

[Chuckanut]

The reason the market expects 2.4 pct inflation is due to our projected population growth i.e., slow. Assuming the Fed does its work, and the government stops overspending, inflation should head toward that steady state rate.
.

emphasis added


I have seen nothing that indicates that Federal government is going to try and restrain spending significantly. As I mentioned in another post the Deficit Hawks now seem to be an extinct species. The Fed can only do so much if those who control the Federal purse strings can't exercise some reasonable level of restraint.

I am carefully watching the price of food and housing, especially rent. This is going to be a hot button as time goes on, IMHO. Groceries, housing, gas.... ""Its the economy, stupid", as they used to say.

In my mind this is very similar to the late 70's and 80's except for the fact that our elected leaders are taking inflation even less seriously now than they did in that previous time. Not so good. I hope I am wrong.

 

[Mr._Graybeard]

Multiple posts with broken quotes were edited.

Voodoo economics was a term that President Bush used when describing economic policies of Pres Reagan. Inflation took off in the US during Pres. Ford’s term and continued during the following term of Pres Carter. In both cases it is unlikely to have any partisan cause. Petroleum price increases combined with poor monetary policy (non-partisan Fed, not elected gov’t) were the drivers.

+1
Inflation back then was a worldwide headache, as it is now. The US is currently doing relatively well if you compare with other countries because the dollar is so strong. The euro has dropped below 99 cents at the moment of this post, the pound is at about $1.13 and the yen is at 144 to the buck. I'm sure the countries using those currencies would love to have our inflation problem instead of theirs.

 

[GaryInCO]

Gee. My property taxes are only $288..................a week!!

Ya that's pretty bad. Mine are "only" $112 a week. What state are you in? Crazy-high taxes, or do you live in a palace, or ...?

My taxes had been basically flat for 20 years, which was nice. Then this year they jumped ***74%***. I hope they don't intend to keep doing that ...

 

[Montecfo]

The video in the OP i thought was very clear and logical. Still the equity market seemed surprised when inflation fell only slightly in the August print.

Wacky markets for sure.

 

[daylatedollarshort]

Ya that's pretty bad. Mine are "only" $112 a week. What state are you in? Crazy-high taxes, or do you live in a palace, or ...?

My taxes had been basically flat for 20 years, which was nice. Then this year they jumped ***74%***. I hope they don't intend to keep doing that ...

That is why California implemented Prop 13, which limits property tax increases. Before that seniors were getting forced out of their homes due to not being able to afford property tax increases as their homes went up in value.

 

[Gearhead Jim]

I have TIPS in retirement accounts so I have to pay taxes on them anyway. The ones we own all have real yields, not 0% like current I-bonds. I'm not going to post my exact numbers but I will post some examples of how one can come out ahead with high inflation. In our case we have a low fixed interest mortgage and our property taxes don't go up much because of Prop 13 annual caps. That leaves our other expenses, which we try to continually optimize, so our personal inflation rate tends to go down, not up, over time.

If you have a 3% rate, $300K mortgage and have the money invested in 2% TIPS making 10% with 8% inflation, that is an extra $21K a year on the difference ((10 - 3) * $300K). The mortgage is fixed so the higher inflation goes, the more one makes on the difference. IN another scenario, if you have $1M in 2% real yield TIPS and $50K in annual SS benefits, and $50K in inflation adjusted annual expenses, and inflation runs 9%, then SS COLA increases should cover your inflation expense increases and you have $110K in TIPS income leftover, 8% to match inflation and a 2% real yield.

Low expenses subject to inflation, low fixed rate mortgage, TIPS / I bonds with real returns, SS, COLA pensions, real estate and other assets, rental income - I would think there are many scenarios where people could come out ahead with high inflation. Even better if they have low overhead and their personal inflation rates went down every year instead of up.

I still need help understanding this.
If your TIPS are paying inflation + 2%, don't you end up paying taxes on all of the gains, sooner or later?
So if you are gaining 10% per year from the TIPS yield plus inflation coverage, and you are in a 20% federal tax bracket, you are getting 80% of your "gain" and the feds take the rest. Similar problem with increases in Social Security and most COLA pensions. That's basically a break-even situation with inflation; good in today's enviornment but very far from "come out ahead".
Please explain further.

 

[daylatedollarshort]

I still need help understanding this.
If your TIPS are paying inflation + 2%, don't you end up paying taxes on all of the gains, sooner or later?
So if you are gaining 10% per year from the TIPS yield plus inflation coverage, and you are in a 20% federal tax bracket, you are getting 80% of your "gain" and the feds take the rest. Similar problem with increases in Social Security and most COLA pensions. That's basically a break-even situation with inflation; good in today's enviornment but very far from "come out ahead".
Please explain further.

I just threw that out as an example. I didn't post my exact portfolio or budget. My TIPS are all in retirement accounts so I have to pay taxes on them no matter what they are invested in. Taxes are one of the expenses in my subject to inflation expense categories.

Here is another example. Take a mortgage for $500K mortgage costing 2% and TIPS earning 10%. That would make 8% on the spread or $40K a year, which can then be reinvested to make even more money. Over the life of a 30 year loan, that really adds up.

Assume that same person has a COLA pension and SS making $100K and $50K expenses. If inflation runs 10%, their expenses will go up $5K and income will go up $10K. Say their personal inflation rate is -2%. Then their income goes up $10K and their expenses decrease by $1K.

There are all sorts of scenarios where one can come out ahead in high inflation. Say another person has $1M in paid off rental rental properties. Usually rent and home values at least keep pace with inflation, so at 10% inflation they are likely going to do well long term.

High inflation itself isn't even bad for fixed income investors. If inflation is 10% and interest rates are 15%, then it works out. What is rough right now is real interest rates are so low but the Fed seems to be fixing that. High inflation usually only hurts investors with fixed income payments like long term low interest bonds not in a ladder, fixed pensions or fixed annuities not offset with fixed expenses. And then there is the issue we've gone over many times on various threads regarding the difference between individual bonds and bond funds without maturity dates in a rapidly rising rate environment.

 

[Montecfo]

TIPS do not pay interest to cover inflation and taxes. Only inflation.

And like most bonds TIPS have declined in value this year as investors have fled bonds.

Given that, I wonder if TIPS might be a better buy in the secondary market right now than at issue. Might be something to look at.

 

[MichaelB]

Given that, I wonder if TIPS might be a better buy in the secondary market right now than at issue. Might be something to look at.

The risk of TIPs in the secondary market is deflation can subtract from the accrued prior inflation adjustments all the way down to the original face value at maturity. Just something to keep in mind.

 

[Montecfo]

The risk of TIPs in the secondary market is deflation can subtract from the accrued prior inflation adjustments all the way down to the original face value at maturity. Just something to keep in mind.

True. It is a characteristic of TIPS. You are only guaranteed the original face and coupons.

I am just thinking the decline this year may present an attractive buying opportunity given longer term market expectations for low inflation.

 

[daylatedollarshort]

TIPS do not pay interest to cover inflation and taxes. Only inflation.

And like most bonds TIPS have declined in value this year as investors have fled bonds.

Given that, I wonder if TIPS might be a better buy in the secondary market right now than at issue. Might be something to look at.

If you sell prior to maturity, you can lose money when interest rates go up, as with any bond. But then that defeats the advantage of having a maturity date if you do that. I wouldn't buy TIPS planning to sell them prior to maturity. If you hold to maturity you get the par value or par plus accumulated inflation, which ever is greater.

TIPS rates have been going up with the interest rate increases. If we have deflation fears that is usually a good time to buy for the long run, because they aren't a good deflation hedge so the prices go down. Though even now the real yields are getting to be attractive again.

 

[daylatedollarshort]

Back on the how to come out ahead with high inflation, I made a spreadsheet prior to retirement with real interest rates and inflation as parameters so I could model different scenarios. I think that really helps to visualize how, year by year, the portfolio and NW can change over time under different inflation / real rate scenarios.

 

[daylatedollarshort]

The economist's predictions seem to be holding true:

Key inflation measure climbs to 40-year high as Fed efforts ring futile and shoppers brace for more pain (msn.com) "Shelter prices led the way, with the government's related index climbing 0.7% through the month. Housing counts for roughly one-third of the average household's spending and counts for an even larger slice of core inflation. While gas and food inflation has generally eased up from levels seen earlier in 2022, housing costs are taking their place."