Thinking Ahead About Inflation And The Federal Debt?

While the struggling economy has put a vice on inflation, many experts don’t expect things to stay that way for much longer. Why? Many economic experts fear the current level of federal spending will inevitably lead to printing more money, and that’s regarded as an inflationary solution.
Recently, the Office of Management and Budget released its Mid-Session Review of the federal budget. While the numbers were not surprising, given the deep recession, they were still huge, projecting a cumulative $9.1 trillion in deficits over the next decade. Left unchecked, this rising tide of debt could boost Treasury interest rates substantially, while only postponing harder choices for a later date. Alternatively, Washington may decide to make some of these choices today, and attack the debt problem through lower spending or higher taxes, or more indirectly, through encouraging stronger economic growth or higher inflation. The key point for investors is that the federal debt is now so big and growing so fast that either path it takes, in the absence of action or any steps taken to correct it, will profoundly affect the investment environment for years to come.
The speed with which the fiscal situation has deteriorated has been breathtaking. Just one year ago, in the Mid-Session Review of the last budget of the Bush Administration, the federal budget was expected to move from deficit to surplus in 2012 with debt equaling 36% of GDP. Today, the deficit is expected to be almost $800 billion in 2012 with the debt at over 71% of GDP and rising.
One reason for this swelling tide of deficits is the measures taken to try to stabilize the financial system and jumpstart the economy—$700 billion in TARP money and $787 billion in fiscal stimulus is serious money. However, the biggest problem has been the recession itself. The Administration now projects that the unemployment rate will average 9.8% next year and fall by an average of just 1% per year over the next four years, reaching 5.9% in 2014. This massive unemployment will erode the tax base while boosting social spending. Meanwhile, interest costs on the debt incurred over the next few years rise very sharply, and by 2019, these annual interest costs reach $774 billion, accounting, on their own, for almost the entire annual deficit.
There are basically four ways to deal with a debt problem. You can try to cut your way out, tax your way out, grow your way out or inflate your way out. Alternatively, it is worth considering the implications of doing nothing—or in other words, letting the debt grow along its current path.
The most obvious impact of this decision, or rather non-decision, should be higher Treasury interest rates. As this is being written, 10-year Treasury bonds are yielding a super low 3.4%. However, it is hard to see how they can stay there in the face of a rebounding economy and soaring debt.
The problem is that vastly increased government debt, relative to the size of our economy, pushes up real yields on Treasuries—that is, Treasury yields less inflation. More people have to be induced to lend money to the government and they will need significant encouragement to do so.
A simple regression analysis, modeling changes in real 10-year Treasury bond yields as a function of real 3-month T-bill rates, the federal debt-to-GDP ratio and the change in the federal debt-to-GDP ratio, explains 88% of the variation in real 10-year yields over the past 54 years. This model, combined with the Administration’s own forecasts of short-term interest rates, federal debt and inflation, suggests that the 10-year Treasury yield could rise as high as 6.5% in 2014 from 3.4% today, as the federal debt soars from 55% of GDP to 72% of GDP and the Federal Reserve maneuvers short-term interest rates back to normal levels.
It should be emphasized that this model, or indeed any statistical model, has severe limitations given profound changes in global financial markets and investor attitudes over the past few decades. It is possible that increased personal savings, both here and abroad in the wake of the financial crisis, will partly absorb this increased supply of Treasury bonds. On the other hand, the U.S. government will be trying to borrow this money at a time when governments around the world are also trying to tap the world’s capital markets. However, the biggest economies outside the United States are also bleeding red ink. This suggests that the traditional safety valve of foreign purchases of U.S. Treasuries won’t be sufficient to absorb our growing debt and that the Treasury will have to offer higher interest rates to move it. These higher Treasury rates, needless to say, would inflict capital losses on current Treasury bond holders.
There are other issues, of course, also associated with the “do-nothing” scenario. Some have worried that the U.S. dollar might fall sharply from the weight of all this debt. However, the obvious question is, “Against what?” The fact that the Euro Area, Japan and the U.K. are facing similar economic and budget problems to the U.S. reduces the risk of a dollar collapse against the world’s biggest currencies. Having said this, the next few years may well see the dollar decline against some emerging market nations that have been less impacted by the crisis.
Another concern is that rising Treasury bond yields may also have the undesirable impact of “crowding-out” some private sector investment that otherwise would have occurred. This could be an issue for capital spending in general, but it is perhaps more of an issue for the housing market, where a rebound in 30-year fixed rate mortgage rates towards 8% could slow the recovery of this battered sector.
As of late August, the federal deficit was estimated at $1.58 trillion and expected to increase roughly $1 trillion more based on the final size of President Obama’s healthcare plan. Even if inflation moves slowly, it’s not a bad idea to at least start thinking about some savings, spending and investment strategies that take inflation into account. Here are a few:
Beware of Treasuries: An economic recovery combined with burgeoning federal debt could push 10-year Treasury yields above 6%, eating into total returns on short-term maturities and generating actual losses on longer-term bonds.
Recognize the risk of higher taxes, particularly if you are wealthier than average, and take advantage of tax-aware strategies.
Build a bigger nest egg: Any attempt to deal with the deficit will likely involve higher taxes on the rich or lower spending on the elderly, because this is where it is easiest to raise revenue and slow spending. If you are older and richer than average, then you are in the crosshairs.
Refinance if it makes sense for you: In March, April and May of 2009, mortgage rates were at 50-year lows. While they’ve largely bounced around in recent months, an economic recovery may mean rates are headed up.
Consider laddering CDs and other interest-bearing savings vehicles: For emergency funds and other forms of savings, a rising rate environment is actually a good thing. “Laddering” means buying CDs, T-bills or other similar investments consistently, so they’ll mature on a consistent basis. Like the steps of a ladder, this process allows a saver to deposit money on a specific date each month – for example, the first of the month – so as each month goes by at hopefully higher interest rates, you can build the nest egg faster.
Consider TIPS: Treasury Inflation-Protected Securities (TIPS) are Treasury securities whose principal and coupon payments are indexed to inflation based on the movements of the Consumer Price Index (CPI). Like ordinary Treasury securities, TIPS have a fixed coupon interest rate but principal is adjusted to reflect the inflation rate. If inflation goes up, the amount of principal to be paid at maturity rises. Coupon payments rise along with the principal since the rate is calculated on the principal amount. If your bet goes wrong and there’s deflation, you won’t lose your principal. There’s a floor at par. When rates rise, TIPS lose value, but they tend to lose a little less because of inflation protection. It might be best to own TIPS in an IRA or other tax-advantaged account because the periodic inventory adjustment is subject to ordinary federal tax at intervals before the bond matures.
Sometimes, when you pass an angry dog on the street, you are advised to ignore it and it will go away. This is not such great advice, however, if it lunges for your throat. The federal debt today is like an angry dog and, for investors, the best strategy is not to ignore it but rather to build a strategy to protect against it.

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