Tags: tolerance | above | average | inflation | dangerous

New Tolerance for Lofty Inflation Is Dangerous

New Tolerance for Lofty Inflation Is Dangerous

Jeff Mount By Wednesday, 02 September 2020 08:31 PM EDT Current | Bio | Archive

Federal Reserve Chairman Jay Powell recently announced a policy for tolerance of higher than average inflation rates for short periods of time. Although the language has changed, the actions really haven’t changed.

The Fed has kept rates near zero for quite some time. What has changed is this language around being “flexible” about one of the two mandates for the Federal Reserve. There was a time when managing inflation was the only real mandate of the Federal Reserve.

I recognize Mr. Powell suggested they would only tolerate heightened levels of inflation for a short period of time, but it seems rather arrogant to me that these economists think it is easy to control inflation once that genie is out of the bottle.

There was also no clarification as to how long they would tolerate inflation or how high they would let inflation climb in order to achieve an “average” inflation rate of around 2%.

Perfect Storm Swells Debt

To be fair, the country is in one of the most incredible periods it has ever seen. People were forced to stay home, not work, not generate revenue to support their businesses or families, and in return, the U.S. government gave many people money through one program or another. The U.S. government had no choice but to do what it did. The challenge is that the country already had an excessive amount of debt and now our debt/GDP is 136% as of July 30, 2020. Our nation’s debt has swollen to heights we have never seen before. As of July 30, 2020, we have $26.5 trillion in debt. Our GDP is only at $19.4 trillion. The question is, how are we going to normalize the economy, minimize the economic pain of this debt, and how can families prepare for the potential consequences of all of this?

Post-Election Directions

We have two possible directions after the November elections. If the Democrats take control of the White House and both houses of Congress, we will most certainly see an increase in taxes that will hit the upper and middle classes. The justification for these taxes will be to help us recover from this economic situation we are currently in, but those dollars will most certainly go towards social programs for the lower class, rather than to pay down this exorbitant amount of debt. If the Republicans do well in the election it is unlikely we will see a tax increase.

The last time a Republican raised taxes was after campaigning with a slogan that read, “Read my lips, no new taxes!” President George H.W. Bush never recovered from that and served only one term in the White House as a consequence. What is the consequence of doing nothing? With a debt/GDP ratio of 136%, the U.S. government will see interest payments on this debt become one of the highest budget costs moving forward. This is the trap we are in. If the Federal Reserve raises rates in the future to combat inflation, they will be raising the interest payments on this debt as well. That would be political suicide.

There is an urban legend about what life was like in post-World War 1 Germany. The German government had an enormous amount of reparations to pay the Allies and turned towards runaway inflation as an exit strategy. By allowing inflation to take hold at a very high rate, it naturally reduced the economic significance of the reparations. The legend refers to a shepherd. Legend has it that the largest farm in that country sought a large loan to expand their operations. This large loan had a long maturity and a manageable interest rate. Rapid inflation occurred shortly after that period and the entire loan was paid off with the sale of one sheep in just four years. I’m not sure if this urban legend has any truth to it, but it clearly demonstrates how a country can manipulate the economic consequences of debt. What real cost is felt by the citizens, however?

Case in Point

Let’s imagine we are dealing with a married couple who are 55 years old and planning on retiring in ten years. They project they will need $12,000 per month (in today’s dollars) to fund their desired retirement lifestyle. They already have $2 million saved for retirement and add $1200 per month into their retirement plans at work. They are invested in a growth-oriented portfolio now and expect solid returns but understand the challenges of receiving stock market returns while in retirement. Therefore, they are calculating an average return of 6% as an average of their pre-retirement and post-retirement investing experience. They are currently projecting a 2% inflation rate. I have inputted these assumptions into the Dynamic Map app (a free financial planning calculator). The graphs below show the retirement liability along a timeline at the bottom and the family’s assets along the timeline at the top.

Let’s see how they would do:

As you can clearly see, Jeff would have enough money to pay his family’s income to age 100 and beyond (and this doesn’t even account for potential Social Security income). However, if the inflation assumption had to increase to even 3%, the picture does not look as secure.

If the inflation genie continued to rise and cause more havoc and go to 4%, the situation becomes really challenging!

Take note of how much of an increase there was in needed retirement assets at age 65 in each scenario. These slight increases in inflation can cause massive shortfalls in income due to the increased capital need.

Unlike an emergency reserve account, which is invested in very conservative, liquid investments, an inflation reserve account would need more asset classes that do assume risk. What makes this challenging is how these asset classes have to be actively managed through the inflationary period. The most common asset associated with inflation is gold. However, the early part of an inflationary cycle does include economic growth, so investments in growth stocks and commodities like copper (often associated with rapidly growing economies) will generally appreciate significantly. However, as interest rates rise, bonds begin to look more appealing due to their higher dividends and more conservative nature, and stocks become more challenged. Even dividend-paying stocks (often seen as blue-chip stocks) become challenged on the back end of an inflationary period. There are many other asset classes to consider and active management through these periods will be helpful in maintaining an investor’s lifestyle.

I don’t know how soon this could all happen (nobody ever does). However, the trap we are currently finding ourselves in is a serious one that can only be solved by making some very politically unpopular actions in the near future. We clearly won’t hear any of that talk leading up to an election. Keep your eyes and ears open to what is being said after the election is over!

(Mike Helgesen is co-author of this article).

Jeff Mount is president of Real Intelligence LLC. Jeff has been active in the financial services business for the last 25 years.

Mike Helgesen is a financial expert and director of development at Real Intelligence LLCMike has been in the financial services business for over 30 years and was the creator of Dynamic Mapping, a unique financial planning method helps consultants to know their client in a way that traditional financial planning does not.

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With rates kept near zero by the Federal Reserve for quite some time, the Chairman has changed language around being flexible in managing inflation.
tolerance, above, average, inflation, dangerous
Wednesday, 02 September 2020 08:31 PM
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