By now, we’ve all experienced the impact of inflation. But just how long will we have to feel the pinch? In this episode of The Agent of Wealth Podcast, Bautis Financial Wealth Manager and Founder Marc Bautis provides an in-depth overview of inflation and explains that there is an end in sight.
In this episode, you will learn:
- What is inflation?
- What’s behind rising inflation?
- Has inflation reached its peak?
- How the Federal Reserve seeks to tame inflation.
- Silver linings to high inflation.
- And more!
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Disclosure: The transcript below has been lightly edited for clarity and content. It is not a direct transcription of the full conversation, which can be listened to above.
Welcome back to The Agent of Wealth Podcast, this is your host Marc Bautis. When I look for topics to cover on the podcast, I usually pick something that I’m getting a lot of questions about, or something that’s getting a lot of coverage in the media. Right now, there’s nothing that’s getting as much attention as inflation. Inflation is the reason that the Federal Reserve is raising interest rates. It’s the primary reason that we’re hearing about an upcoming recession. Plus, we’re all feeling it in everything we spend money on. Inflation is also causing a lot of volatility in the markets.
So on today’s episode, I’ll cover everything going on with inflation and then answer the question: When will we hit peak inflation?
What is Inflation?
Inflation is simply a rise in prices, which ultimately results in a reduction in purchasing power. Unless you’ve been hibernating the past year, you’ve definitely felt inflation as a consumer. Prices on just about everything have gone up.
We felt inflation at the gas pump. Food prices are astronomical, whether it’s your weekly grocery bill or eating out… I recently saw a cheeseburger priced at $20. But it’s not just food and gas, it’s everything we spend money on.
But we don’t just feel the pain of inflation at the cash register. Most people are used to spending every dime of their income, which makes it hard to adjust when the price of goods and services are soaring. As a result, in inflationary periods, many people wind up spending more money than they have.
So when expenses increase, say 10%, because of inflation, it can become a significant problem. Instead of making lifestyle changes and cutting back on spending, many people turn to credit – and that credit card debt continues to add up.
Or, just as bad as increasing your credit card debt, some people will cut back on saving, whether it be in their 401(k) or some other savings vehicles. A recent Morgan Stanley study found that 31% of US workers have reduced their 401(k) contributions over the past year.
If expenses are rising, something has to give. Yes, wages and income have risen as well, but not as much as inflation has. So people are trying to figure out what they can do to get by, and it really comes down to two options: reduce expenses or increase income.
As a result, people are forgoing their 401(k) contributions.
Individuals are also reducing 401(k) contributions because the market has dropped. Right now, investors aren’t confident in the economy, and some people believe it’s not worth investing… when in reality, it’s probably the opposite when you consider dollar cost averaging. You can make the argument that you should be increasing, or at least maintaining your 401(k) contributions because of dollar cost averaging.
But everyone’s situation is different. When it comes to making a decision on whether to put food on the table or save in a 401(k), ultimately putting food on the table is more important.
Inflation can also hit retirees really hard. They may have fixed income, or they may have run projections on how long their money will last… and all of a sudden inflation puts a wedge in their plans. Inflation can also eat into premiums, like Medicare. We’ll talk more about that in a few minutes.
What’s Behind Rising Inflation?
As a country, we’ve been in a period of easy monetary policy, or easy money, for over a decade. The Federal Reserve, and the government, want to keep the economy humming along, so they do what is called quantitative easing,
Quantitative easing is often used when interest rates hover near zero and economic growth is stalled. Central banks have limited tools, like interest rate reduction, to influence economic growth. Without the ability to lower rates further, central banks must strategically increase the supply of money.
To execute quantitative easing, central banks buy government bonds and other securities, injecting bank reserves into the economy. Increasing the supply of money lowers interest rates further and provides liquidity to the banking system, allowing banks to lend with easier terms.
All of this is done to hopefully give a boost to the economy, but because banks are encouraged to lend, there’s money all over the place.
The easy monetary policy started during the bursting of the U/S/ housing bubble and the global financial crisis in 2008-2009. But it was definitely accelerated by the COVID pandemic, by government programs such as the stimulus package.
Over those years, each time a new easy monetary policy was passed, you’d hear someone say, “That bill will be due at some time, who is going to pay it?” Well, us… because inflation is the byproduct.
Here are some examples of what it looks like.
Let’s say I wanted to buy a house. I have cash for the down payment, and I have no trouble getting a low-interest loan because, like I said, banks are encouraged to lend money. Because the monthly mortgage payment will be low, due to the interest rate, I can make a bigger offer on a house.
But, there’s 20-30 people in the same boat. Like the law of supply and demand demonstrated, if everyone is flush with money and interested in purchasing a home, the prices of the houses will increase. Then, that snowballs, because the singular home that sells over it’s value drives up the market value of the next home that goes on the market in the neighborhood.
Another example: Let’s say a company is looking to hire employees. The same way that an individual can obtain a low-interest loan for a home, a company can obtain a low-interest loan for their business. Backed by the bank, the company can now offer an employee a higher salary. While that’s great for the individual, if a lot of companies have access to a lot more money, it drives up wages across the board.
Left unchecked, inflation can get out of control. While inflation in the U.S. will probably never get to the levels it’s like in Venezuela or Argentina, it can still be destructive if it’s left to run rampant.
How The Federal Reserve Seeks to Tame Inflation
That’s where the Federal Reserve comes in. The same way they can set easy monetary policy, they can do the opposite. And they have: This year’s interest rate hikes began In March 2022, when the Fed raised its federal funds benchmark for the first time since 2018. Since, there’s been five more hikes:
As a result of raising interest rates, the Fed aims to tighten the money supply and tame inflation.
But they do have to play a balancing act. If the Fed raises rates too fast, they risk crushing the economy – that’s called a “hard landing.” The Fed’s goal is to keep the economy healthy and, instead, have a soft landing.
The fact that the economy has its peaks, valleys, expansions and contractions is nothing new. But it’s the time frames between each of those peaks and valleys that differs each time. But remember, the current state of our economy is nothing new. It’s happened before. The uncertainty around the timeline is what is making markets react. Unfortunately, the market never reacts to uncertainty well.
The Silver Linings to High Inflation
Now, there are some silver linings to high inflation.
For one, the IRS released inflation-adjusted marginal rates and income tax brackets for 2023. Because of the high inflation environment we’re in, tax bracket income thresholds are shifting to the right. That means some of your income may be taxed at a lower rate, which could result in savings.
Now, the tax brackets didn’t shift at the same rate as inflation, but it’s better than if they didn’t change at all. There’s also increases in the estate tax exemption and the gift tax thresholds.
Secondly, the cost of living adjustment (COLA) for Social Security in 2023 has been increased to 8.7%. That extra income may increase your Medicare premium – because it may bump you up into a higher bracket – but ultimately it should be a good thing.
One question I get about the Social Security cost of living adjustments is: If someone is not already claiming Social Security, will they still benefit from the higher COLA? The answer is yes. Even if you’re not collecting Social Security, that 8.7% cost of living adjustment is still built into your future benefit. So there’s no need to worry if you aren’t yet collecting Social Security.
Another silver lining is that fixed income is becoming more investible. I Bonds have had a high interest rate throughout the year. Although, rates did just reset on November 1st and they’ve come down a bit. They’re going to reset again in May, but the rates are still high due to inflation.
Related: How I Bonds Can Hedge Against Inflation
T-Bills have also become investible. T-Bills can be a three-month, six-month or one-year treasury, and those rates are around four percent. You don’t see that rate for something with such a short maturity very often.
Previously, when we’d build a portfolio, we’d include fixed income mainly as a hedge against falling stock prices. Over the past decade, interest rates have been so low that almost any fixed income insurance was kicking off a measly yield – so no one was getting rich off of yields on bonds or fixed income. This year, the hedge didn’t hold up well because interest rates have risen exponentially against falling stocks. But like I mentioned, their yields are now worth considering.
Related: Should You Add Fixed Income Investments to Your Portfolio?
There Is An End In Sight
The biggest question we have right now is, when will we reach peak inflation? There are a couple things to note here.
One, I mentioned that I Bonds yields reset on November 1st, and while they’re still high at 6.89%, they’re lower than before. So that may be one indicator that the end to inflation is in sight.
Also, October was the stock market’s best month since 1976. On a recent podcast episode, I talked about how the stock market is a leading indicator. And it’s true: the stock market is already ahead of time. The drop in the market this year was because of the potential for a recession next year. So, the gain in October could signal that the end is in fact in sight.
What Economists Are Saying
David Rosenberg thinks that inflation will drop from the current 8% to 3% next year. Now, he does warn that the Fed has to be careful because they’re rapidly hiking interest rates, even though stocks are in a bear market and the overall economic outlook is unclear. He thinks that if the Fed keeps tightening the way it has, it could take the housing sector down and spark a credit crunch in the banking sector.
James Paulsen thinks inflation has rolled over and will continue to decline. He claims that historically peak inflation has been a very good time to buy stocks. His reasoning is that the S&P 500’s valuation is at a relatively low level and that investor sentiment is very pessimistic, which is often seen as bullish for stocks. Paulsen, like Rosenberg, thinks the Fed tightening has gotten extreme and could have a severe impact if it continues.
A recent Bank of America survey of fund managers found that 87% of them believe inflation has peaked. 79% think that it will fall over the next 12 months. Fund managers also believe that we’ll see a capitulation rally. This is a concept where if prices fall for an extended period of time, like we’ve seen this year, a majority of investors will panic and capitulate or sell their holdings, which essentially is rock bottom. That’s when that selling pressure comes to an end and a market rally follows.
In all three examples, the economists think we may be seeing peak inflation, but they all agree that the Fed is walking in a tight rope. We won’t know for sure when inflation will peak until after it happens. But like I mentioned earlier, this isn’t the first time that we’ve been in an inflationary period or where things in the market look scary.
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