With the inflation data in for January 2023, we stood at 6.4% higher than prices in January last year. While that is lower than the previous month and the seventh consecutive month prices have come down, they’re still quite high. Not only that, prices have increased from December into January which shows inflation may be a bit more challenging to keep down than the Fed had hoped.

What was the driver on the recent inflation figures?

With many of the supply chain issues subsiding, goods like cars and semiconductors becoming more available and prices are cooling. Prices on other areas such as restaurants, health care, hotels, and other services have been taking the baton and driving the inflation numbers. Most of us have had the experience in the service sector seeing exactly what things look like when good workers are difficult to keep. This is driving labor prices higher to attract talent and keep businesses running smoothly.

How far can the Fed push up interest rates?

The Fed’s target is to get inflation down to their 2% target range but are they willing to push rates higher until they get there? Unlikely due to a variety of factors. There are a handful of structural inflationary drivers that are mostly out of the Fed’s control.

• Cheap labor – The post-pandemic labor force has much more power than they had before. Businesses are competing to keep quality people and needing to pay up for that. Employees have much more choice now and many choosing a job with a flexible, controllable schedule over a job that comes with a boss and getting yelled at by the public.
• Cheap goods – Manufacturing goods to be made overseas has slowed down due to conflicts in China and the pandemic which proved those supply chains to be fragile. This trend of producing things in the US is great for jobs but it does mean higher prices for consumers.
• Cheap energy – Finally, energy investments have been at extremely low levels not only in the US but globally. We have enjoyed low energy prices for the 2010’s decade due to massive investments in the early part of that stage but unless the wind and solar investments that have been made can save the day, higher energy costs are likely ahead of us.

These structural issues are mostly out of the Federal Reserves control, short of them triggering a major recession which is difficult to see them doing with all of the political pressure on them.

The $30 Trillion dollar Elephant that could keep rates down

Enter the $30 Trillion Elephant in the room. That is the balance of the US government debt. The total balance actually hasn’t been an issue up until now. The urgency now is the interest rate and thus payments are to reset higher based on interest rates increasing.

The current annual interest expense is approximately $730 billion per year, implying about a 2.43% interest rate on average. For reference, the 2nd and 3rd highest expenses for the federal government is military/defense, and Medicare coming in at $735 billion and $689 billion per year, respectively.

To be sure, folks have been screaming about the government debt for years but we may be at the point where it starts to get interesting. The annual interest expense rises by about $300 billion per year for every 1% increase in that average rate. Now the average interest rate on the debt does not go up in lockstep with the Fed’s target rate, it some time to take effect as old bonds roll off and they get replaced with new higher cost bonds.

With that said, if the average rate on the debt rises to 4.34%, the annual interest payments rise to approximately ($600 billion added to the current $730 billion annual cost) $1.33 trillion per year. This assumes the debt balance doesn’t rise, which is projected to go up by another trillion or two this year. What’s another trillion anyway?

Let’s pretend the US government is a spendy US citizen for a moment. This would be the equivalent of spending $1.5 trillion per year more than he earns. His credit card balance is $33 trillion and the interest charges per year are about $730 billion. If rates stay where they are for a few years, the interest payments go up to about $1.33 trillion per year. And for fun, for every new trillion dollars of debt caused by interest charges, the new interest added to that is another $43 billion per year. That change is the result of a 2% increase in rates!

Paying back the debt with inflated dollars

The most realistic and probable way to solve the debt problem is to inflate it away. Let inflation run warm for a while which allows the government to pay back the fixed debt payments with inflated dollars. They can’t afford the damaging effects of runaway inflation, but I do think a “managed inflation” scenario as being one they settle for. This could be the case while Jay Powell is talking tough against inflation. It’s very possible in 2023 he veers off the 2% inflation target and declares some type of victory saying it’s been solved for now and they’ll “keep an eye on it” He could also come up with a reason why the 2% target is now outdated and change the rules on what the new “better” measure is. They have already been wavering on what they use to measure inflation whether it’s CPI, which measures a broad basket of items. “Core inflation” is another measure which excludes food and energy prices… Finally, we have “PCE or Personal Consumption Expenditures” which measures other slightly different baskets.

The timing and nuance to how all of this plays out is anyones guess but the math is hard to ignore. To set additional context, the US is not unlike other countries like the European Union, Japan, and others that have much worse fiscal balances. This is a large reason why the US dollar has remained quite strong through the past year and why many large investors consider the US a safe haven compared to the other global players. Many top economists see the US as the best house in a bad neighborhood of fiscal balances and see the US dollar remaining very strong for quite a while. There are also other factors like most major commodities being priced in US dollars which creates a demand for them thus provides us an incredible structural advantage compared to other currencies.

Where is the recession?

With the increase of rates from close to zero to almost 5% in 1 year, where is the recession? The unemployment rate is still at record lows, the housing market has slowed but not showing any signs of the crash we saw in 2008, so what gives? Most people have been saying the Fed is going to “break” something and then pivot.

Corporations terming their debt out

Perhaps the break is coming later but there are structural things in play that are making the economy resilient. For one, during the pandemic year, many companies termed out their debt at the record low rates for 3-5 years plus. These companies have had zero impact to their cash flows when the Fed raises rates because they’re still paying the low rate on their debt they issued in 2020. This of course will eventually take its toll as these bonds need to be refinanced at higher rates, but have bought themselves time.

Savvy Homeowners

Homeowners have behaved very differently than they did in 2008. Similar to companies, many have refinanced several times as rates got lower and lower. Most homeowners that have debt use a 30-year fixed mortgage after learning the lessons of the early 2000’s with variable mortgages. There certainly has been plenty of speculation in the housing market, but the documentation on loans required by banks is far more rigorous now. Many individuals that would like to upgrade to a bigger home now may be forced to stay where they are and upgrade rather than buy a new home. This behavior doesn’t create a crash though, it just reduces the inventory of homes for sale as more folks keep what they have due to affordability from higher rates.

Let’s take the homeowner with a $750,000, cozy 3-bedroom home in Massachusetts purchased in 2018 when she was engaged. Since then, she has refinanced several times and now has a 3.2% rate locked in from 2020 and she now has 2 kids and wants a house with 1 more bedroom and a bigger backyard. That new home now might cost $950,000 and the interest rate of 6% sends her monthly payment up 30-50% and she will likely stay put and make the best of things and making upgrades if possible. Not an ideal scenario, but far different from the upside-down mortgages that were reset in 2007 when rates increased and poorly qualified homeowners were booted from their house.

Those are just two examples of how this cycle is quite a bit different from the previous ones. Many investors like to fight the battle of the last war but previous recessions had very different backdrops. The risk of recession is very much real and many have looked to the playbook of the 1940’s coming out of the war or the 1970’s where we had structural inflation.

How investors should prepare for the uncertainty

There is some great news for those closer to retirement wanting to protect their money from all of this uncertainty. Interest rates are now much higher and there is a real alternative to the stock market and riskier asset classes. US treasury bonds and CD’s in the 1-3 year range are yielding quite a bit higher than many dividend stocks in the S&P 500 and have zero risk.

My advice for clients with expense needs within 3-5 years is keep those balances in something fixed and not at risk to the market. Some folks want to lock in fixed rates for even further out, allowing them to know they have “X” number of years of expense needs that is not at risk in the stock market.

Take a client for example with $1.250,000 in investable funds after retiring last year at age 66. She has a 60/40 blended portfolio with 60% in stock funds and 40% in bond mutual funds. With the interest rate risks that bond funds can present, being vulnerable to interest rate increases, opting for individual treasuries or CD’s can provide more certainty and known returns.

Expenses of $80,000 per year and social security payments of $35,000 per year present a gap of $45,000 per year of expenses that need to be covered by portfolio withdrawals. If the 40% bond funds portion of the portfolio are moved to a ladder of fixed treasuries or CD’s paying 5%, that theoretically provides over 10 years ($45,000 X 10) of withdrawals from the portfolio from a fixed source and the yield will generate a real return over that time.

In reality, most retirees don’t withdraw only from their fixed income portions of the portfolio, but it does provide peace of mind to know that 10 years worth of expenses are being met by that safe portion. This can lead to better outcomes allowing retirees to know the portion of their portfolio that is invested in the stock market does not need to be relied on anytime soon.