Tag: Inflation

PCE Inflation Versus CPI Inflation, What’s the Difference?

Posted on by phoffman@channelchek.com
Image Credit: Brenda Gottsabend (Flickr)

The Increasing Popularity of the PCE Inflation Gauge

US inflation, by a number of official measures, reached its highest level in 40 years last year. For a large percentage of investors and shoppers, this is their first experience of prices quickly rising. For decades, on many tech products, prices declined over time (while adding functionality). There are a number of different measures of inflation reported regularly – they impact us in different ways. Knowing the difference, whether you’re investing, planning a purchase, or expecting a cost of living (COLA) increase, is helpful. Below we go through the different measures so you understand the impact of say “headline CPI” versus “core PCE.”

According to James Bullard, the president and CEO of the Federal Reserve Bank of St. Louis,  “measuring inflation is one of the most difficult issues studied by economists.”

By definition, inflation is the percentage change in overall prices in the economy over a specified period, commonly quoted as a year-over-year change. It’s much more than an increase in the prices of a few products. Given the inherent difficulties in following every price in the country, economists have created price indexes to approximate the overall price level.

PCE Inflation

Before the year 2000, the Federal Open Market Committee (FOMC) primarily focused on the Consumer Price Index (CPI) as its inflation gauge. We’ll explain CPI next, but for the Fed, when it now says it has a 2% inflation target, PCE is the data used.

Though the two indexes have a lot of overlap, there are reasons why the PCE is considered a better tool by policymakers.

The PCE price index, which rose 5.5% in November 2022 from a year earlier, is derived from a broader index of prices than the CPI’s more narrow set of goods and services. The argument as to why policymakers gave an edge in the late 1990s to make the change in 2000 is that a more comprehensive index (such as PCE) of prices provides a better way to gauge underlying inflationary pressures. Since the PCE includes more goods and services, the index’s weights for particular items will differ dramatically from those in the CPI. For example, housing has a weight of about 16% in the PCE price index versus 33% in the CPI. The varied items more accurately reflect actual costs to consumers since they may substitute one for another as prices of items change at different rates. This ability to substitute is a primary reason why PCE tends to print lower than headline CPI.

CPI Remains Important

The most widely cited measure of inflation is the headline Consumer Price Index (CPI), which is calculated by the Bureau of Labor Statistics (BLS). This index was created in 1919 as officials devised a way to measure rising consumer prices just after World War I.

The CPI, which rose 6.5% for all of 2022, measures the price changes for a basket of goods and services purchased by the typical urban consumer. The items in this basket are weighted by their relative importance in consumer expenditures. For example, housing—rent and other spending on shelter—accounts for 33% of the index, while medical care accounts for nearly 9%.

This index, like others, takes into account changing consumption. New items come in and old items leave. The example I like to use is that prohibition began in January 1920, just after CPI came into use. Alcohol was not part of the index back then, whereas it is today (5.78% increase in 2022), product adoption changes.

The CPI weights had been adjusted every two years using two years of consumer spending data. Starting in 2023, the BLS will update weights annually using one year of data.

Headline PCE Inflation versus Headline CPI Inflation

The increasing popularity of the PCE is because the index’s weights are updated monthly, versus annually for CPI (prior to 2023 updates were every two years). Thus, the PCE can quickly reflect the impact of new technology or an abrupt change in consumer spending patterns. For example, the onset of the coronavirus pandemic quickly shifted consumption from services like restaurants to services like communication technology. Since the headline PCE uses more timely, actual outlays, it provides the FOMC a more accurate consumer experience in terms of inflation.  

The stated target by the FOMC is 2%, a level that policymakers judge to be consistent with achieving price stability and maximum employment. On average, inflation was hovering below this target before the pandemic’s economic ramifications (from 1995 through 2019 PCE average equaled 1.8%).  

Other Inflation Measures

While the FOMC targets headline PCE inflation, policymakers also watch other measures to gauge inflationary pressures. The headline PCE measure can be quite volatile due to the effects of extreme price movements for certain products. To get a sense of where underlying inflation really is, economists often look at some summary measure of inflation that doesn’t include these volatile prices.

A so-called “core” index—whether it be PCE or CPI—excludes food and energy components. That has some simplicity around it, but it’s not satisfactory. There are better ways to analyze underlying inflation than to throw out certain goods and services, especially those that hit low- to moderate-income consumers the hardest when prices rise. And even if you exclude food and energy prices, the remaining part of the index is still affected by their volatility; restaurant prices would be a classic example.

More recently, other statistical ideas have been developed. One method looks at price change distribution for the entire range of goods and services.3

One commonly used measure of this type is the Dallas Fed trimmed-mean PCE inflation rate, which removes the upper tail (the largest price changes) and the lower tail (the smallest price changes) and then takes a weighted average of the price changes for the remaining components. This measure has been popular as a tool for examining trends and overall inflation as opposed to special factors that might be driving inflation. Of course, these types of measures4 tend to be more persistent and move more slowly than headline inflation measures.

Take Away

While market concerns over inflation for many years were low and most may have been more concerned about deflation, the current tight supply of goods and labor, coupled with the easiness of money, has ushered in a period where markets are likely to feel the impact of each inflation post.

Understanding the most watched inflation gauges will help sort out whether a trend or single post is likely to cause a change in course on interest rates. Or is it more likely a blip that will on average work its way out? The Fed is currently targeting a PCE inflation rate of 2%. The current pace is more than double this, but trending down after the Fed tightened in 2022 at a record pace. The Fed and the markets are now awaiting the impact of those cuts as there is a lag in applying the economic brakes (to lessen inflation) and when the economy has its biggest reaction to the Fed’s heavy pressure on the brake pedal.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.federalreserve.gov/newsevents/speech/powell20200827a.htm

https://files.stlouisfed.org/files/htdocs/publications/review/11/07/bullard.pdf

https://www.usinflationcalculator.com/

https://ycharts.com/indicators/us_consumer_price_index_alcoholic_beverages_unadjusted

https://www.stlouisfed.org/publications/regional-economist/2022/sep/making-sense-inflation-measures#authorbox

How Inflation Clips Age Groups Differently

Posted on by phoffman@channelchek.com
Image Credit: Rodnae (Pexels)

Inflation for Americans at Each Age

According to the Bureau of Labor Statistics, consumer prices rose 9.1% from June 2021 to June 2022, the highest rate since 1981. That figure is an average of price increases for bananas, electricity, haircuts, and more than 200 other categories of goods and services. But households in different age groups spend money differently, so inflation rates vary by age, too. The diagrams below show average spending for households at different ages, in the categories that make up the inflation index.

25 Year-Olds / Full Interactive Graphic

Young households spend more of their budgets on gasoline, where prices rose 60% in the last year. Gasoline has been the largest single-category driver of inflation since March 2021, accounting for nearly 25% of inflation by itself. Gas has had an outsized impact considering that the category is 4.8% of Consumer Price Index spending. (Gasoline prices began falling in mid-June.)

40 Year-Olds / Full Interactive Graphic

Measured in dollars, gasoline spending peaks around age 40, according to government surveys.

Source:
US Bureau of Labor Statistics

But, as a percentage of spending, gasoline spending is highest for the youngest households.

Sources:
US Bureau of Labor Statistics
Consumer Expenditure Survey
Consumer Price Index

Taking an average of all categories, as the inflation index does, shows that inflation is currently highest for younger households. It is about 2 percentage points higher for households headed by 21-year-olds as it is for octogenarians who live at home. That has not been true for most of the last 40 years. Inflation rates calculated in this way were higher for older households as recently as early 2021, when medical care costs were rising faster than gasoline prices.

Sources:
US Bureau of Labor Statistics
Consumer Expenditure Survey
Consumer Price Index

67 Year-Olds / Full Interactive Graphic

These estimates are imperfect. The Bureau of Labor Statistics notes in its estimate of inflation for elderly households that different age groups may buy different items within each category or buy them from different types of stores. They may also live in locations with costs of living so dissimilar that national changes in prices are not relevant. Over the past 12 months, inflation was 6.7% in the New York City metropolitan area and 12.3 in the Phoenix metropolitan area, due in part to different housing markets.

The above was adapted from USAFacts and is the intellectual property of USAFacts protected by copyrights and similar rights. USAFacts grants a license to use this Original Content under the Creative Commons Attribution-ShareAlike 4.0 (or higher) International Public License (the “CC BY-SA 4.0 License”).

Why Rate Increases May be Nearing an End

Posted on by phoffman@channelchek.com
Image Credit: Jernej Furman (Flickr)

Arguments Can be Made for Rates Being Too Low and for Rates Being Too High

The Federal Reserve has raised the Fed Funds rate from an average of 0.08% in January 2022 to its current 4.05%, and a likely adjustment to 4.25% to 4.50% tomorrow. Inflation, as measured by CPI and even the Fed’s favorite, the PCE deflator, has been showing a decreasing rise in prices. So investors within all affected markets are asking, how much more will the Fed raise rates?  Ignoring any suggestion that “this time it’s different,” I looked at US interest rates and inflation going back to 1962 and may have found enough consistency and historical norms to help determine what to expect now and why.

Are Increases Nearing an End?

I’ll start with the conclusion. The data suggests that the movement of market rates depends on whether higher current inflation is being caused by temporary or long-lived factors. The 10-year Treasury Note market believes current inflation is mostly temporary. This is shown by its yield, having touched 4.25% in late October, and then falling. The ten-year is now near 3.50%, despite the 0.75% increase in overnight rates implemented on November 2. If the combined wisdom of the Treasury market is reliable, this suggests FOMC rate increases are nearing an end. Perhaps one more smaller hike and then a wait-and-see period. The Fed would then monitor prices while past increases work their way through the economy.

 

Powell’s Concerns

At his last address on November 30th,  Fed Chair Jay Powell indicated he’d rather go too far (with tightening) and then reignite the economy rather than err on the side of not doing enough and having a bigger problem. The markets and the media largely ignored this, but it’s important to know what the Fed Chair believes is prescient and is sharing publicly.  Powell also said, “Given our progress in tightening policy, the timing of that moderation is far less significant than the questions of how much further we will need to raise rates to control inflation, and the length of time it will be necessary to hold policy at a restrictive level.” And then he said something very telling, Powell added, “It is likely that restoring price stability will require holding policy at a restrictive level for some time. History cautions strongly against prematurely loosening policy. We will stay the course until the job is done.”

Market Thinks Inflation is Temporary

But, the markets are overjoyed by the last two months of inflation data. Despite what the nations top central banker is saying. Markets may be right, but if they are wrong (bond and stock markets) spotting it early can help stave off losses. If inflation, which is lower than it had been, but not historically low,  proves more permanent, for example, if employers continue to have to bid up the price of workers, and demand for goods causes commodity prices to rise, then the Fed will have paused too early. This will lead to a more difficult challenge for the Fed as compared to tightening too much.  The data used in this article are from the Federal Reserve Economic Data (FRED) maintained by the Federal Reserve Bank of St. Louis.

Actual and Expected Inflation

The St. Louis Federal Reserve publishes a market estimate of expected average inflation over the next ten years.  It is derived from the 10-year Treasury constant maturity bond and 10-year Treasury inflation-indexed constant maturity bond.  It was first published in 2003.  Over 2003-2021, 10-year inflation expectation averaged 2.0%, the same as GDP deflator inflation.  During the second quarter of 2022, the expected 10-year inflation was 2.7%, or less than 1.0 percentage point above its 2003-2021 average.  In contrast, GDP deflator inflation was 7.6%.  A significant wedge exists between current and expected inflation.

Source: St. Louis Fed

The breakeven inflation rate represents a measure of expected inflation derived from 10-Year Treasury Constant Maturity Securities (BC_10YEAR) and 10-Year Treasury Inflation-Indexed Constant Maturity Securities (TC_10YEAR). The latest value implies what market participants expect inflation to be in the next 10 years, on average.

Beginning with the end of the last recession on April 1, 2020, the Treasury bond data used in calculating interest rate spreads is obtained directly from the U.S. Treasury Department.

Take Away

The Market’s expectation of 10-year average inflation is dramatically different from current inflation, even at inflation’s new lower pace. This implies the market believes it to be temporary.

If the market’s expectation of inflation is accurate, there is an average difference between Fed Funds and the PCE deflator of 1.6% (since 1962). The last read on PCE was October 2022 at 6%. Reducing this by 1.6 would provide a Fed Funds level of 4.4%. This level is in line with historic averages and likely where we will be after the FOMC meeting wraps up on December 14. This comparatively high rate relative to where we began the year may be considered neutral.

Will the Fed stop at neutral? Are the markets right? Powell said he’d rather err on the side of going beyond what is needed, which suggests the Fed will continue some. As for the markets, being on the side of the markets is how you make money, but getting out before trouble arises is how you keep the money. Markets are not always accurate forecasters and since economic behavior and debt levels tend to adjust slowly, prudent portfolio management suggests it is wise to keep an eye out for today’s interest rates still being too low.

Paul Hoffman

Managing Editor, Channelchek

Source

https://www.federalreserve.gov/newsevents/speech/powell20221130a.htm

https://beta.bls.gov/dataQuery/search

Cathie Wood Expands on Her Expectations of Deflation

Posted on by phoffman@channelchek.com
Image Credit: Singularity University (YouTube)

An Alternative View of Today’s Economy by Cathie Wood

Cathie Wood made the argument that investors comparing the current economic crosscurrents to the 1970s are developing forecasts based on the wrong data-set. Speaking at the Finimize Modern Investor Summit via video, the ARK Invest funds founder instead suggested the current economy and inputs are similar to a different period – she then made a case for her reasoning.

“If you go back to the 19-teens (1912-1922), then the period was very similar to the period we’re in today,” she said at the Investor Summit. That period featured a war, a pandemic (Spanish flu), and supply-chain problems. “It was the most prolific period for innovation in history,” she said, pointing to the disruptive impact of electricity, the telephone, and the car.

Wood explained that inflation went from 24% in June 1920 to -15% in June 2021. She made clear she isn’t forecasting deflation this severe; however, she is expecting year-over-year inflation to swing into negative territory, with prices going down. “What has happened during the last few years is going to flip, and we think that the market will flip back to a preference for growth stocks and our innovation strategy,” she said.

Wood also elaborated on a tweet she issued earlier about how deep the inversion was of the yield curve.

Twitter @CathieDWood

“That’s the bond market saying, ‘hello, Fed, are you watching?'” She said Federal Reserve Chair Jerome Powell is trying to be the reincarnation of Paul Volcker at a time when it’s not appropriate. “I think that’s a mistake because this is not a 15-year problem; it’s a 15-month one,” said Wood. She highlighted that commodity prices are tumbling, supply chains are improving, and companies are

Ark Invest funds have been positioned in a more concentrated waiting pattern while Wood waits for inflation dynamics to be supportive of innovation. She gave an example; the innovation fund, for instance, has been narrowed to 32 companies from 58, Wood said, as she highlighted that the firm has become less convinced China is supportive of innovation.

Take Away

It’s worth reviewing the differing opinions of several investors that have made above-average returns in their careers. While almost no one is always correct, there are many different right ways to make money in any market.

The Ark flagship fund is down 63% this year; in the past, Wood has indicated her funds’ time period to measure return is five years, not one. Perhaps investors with a longer holding period can garner useful ideas from her pounding the deflation drum, while investors with a shorter time horizon are concerned about inflation.

Paul Hoffman

Managing Editor, Channelchek

When Will Monetary Policy Finally Score?

Posted on by phoffman@channelchek.com
Image Credit: Pixabay (Pexels)

Why the Fed Needs to Gain Trust, Gain Momentum, and Gain More Yards

Monetary policy and its implementation is as much sport as science. Economics is actually a social science, so it relies on human behavior to mimic past behaviors as its prediction guide. But as in sports, victory is difficult if there is distrust in the coach that’s calling the shots (in this case Powell), or if there are people on your side that have reason to work against you, (an example would be Yellen). Consistency in blocking and tackling (doing the right thing) and not giving up, over time, wins games. Knowing what to expect from the opposing team (consumers) wins a healthy economy.

One repeated trait in monetary policy is that there is a lag between implementation (easing or tightening) and a change in economic conditions. It isn’t a short lag, and the impact varies. Since it could take more than a year for a policy change to begin to impact the economy, the Fed usually moves at a slow and measured pace in order to not overdo it.

The slow pace allows policymakers to observe the impact of their moves and change tactics (positions on the playing field) mid-game.  

Federal-Funds Rate During Tightening Cycles

Note: From December 2008, midpoint of target range. December 2015 hike excluded from 2016-18 cycle

Source: Federal Reserve

Over the past nine months, we have been in a tightening cycle. During this period, the Fed has raised rates by 3.75%. On average (since 1975), when the Fed has tightened rates, they are notched up by 5.00% over 20 months.

The Fed’s current pace is faster than average. This is because inflation took them by surprise, and rose rapidly. Putting up a strong defense against inflation that has been rampant is necessary to not be shut out and allow the Fed to gain control over the outcome.

Because one has to be able to reflect back more than 40 years to have experienced the Fed raising rates this fast. Many have lost confidence in its ability, and are in their own way working against a winning outcome.

Pace of Fed Hiking Cycles

Note: From December 2008, the midpoint of target range

Source: Federal Reserve

The stock and bond markets move in group anticipation of expected policy moves by the Fed. This has been more pronounced in recent years as the Fed has basically shared its expectations after each meeting, setting up for the next. Higher rates make bonds and bank deposits more attractive. Higher rates also weaken the economy and corporate profits, and that induces investors to move away from stocks and even real estate.

Bonds now offer the highest yields since 2007. The stock market may have anticipated what was to come as it peaked in early January of this year, more than two months before the Fed began hiking in March.

Fed Hikes and S&P 500 Bear Markets

Sources: Federal Reserve; Dow Jones Market Data

Sources: Federal Reserve; Dow Jones Market Data

Employment

The Fed is concerned with a wage-price spiral feeding on itself. It likely won’t be  satisfied that its tightening has been sufficient until it can be confident that it has avoided a wage-price storm on the economy.

Ideally, this would happen without unemployment rising. Soft landings took place in 1983-84 and 1994-95. But when inflation starts out too high, as it is now, unemployment usually rises notably, and a recession occurs.

Historically, this doesn’t happen until several years after the first increase. This time it is hoped it will be different, since the Fed is playing more aggressively.

Periods of Fed Hiking and Rising Unemployment

Note: The unemployment rate rose to 3.7% in October, up from the pandemic low of 3.5% a month earlier.
Sources: Federal Reserve; Labor Department

Inflation

Historically, inflation has only fallen to acceptable levels after unemployment has increased, and long after the first rate increase – the exact timing has varied. If the fall in core inflation (which excludes the volatile food and energy components) between September and October continues, and September proves to be the peak, the time between the first Fed increase and the high point of inflation will be one of the shortest of any Fed hiking cycle.

Often, the break in inflation has been accompanied by a recession. The economy receded in each of the first two quarters and then grew in the third. The changes in the inflation component in Gross Domestic Product may have borrowed from one quarter and have been additive to the next. The fourth quarter reading should help level the growth averages out to see if we were indeed in a shallow recession.

Proximity of Peak Inflation and Recessions to Initial Rate Hikes, from Year Hiking Cycle Began

Note: Inflation refers to core CPI.

Sources: Federal Reserve; Labor Department

Take  Away

As in many team sports, once one side gets momentum, they are difficult to stop . The Fed needs to gain the trust of the individual players in the economy in order to be successful. Saying one thing, then doing another, would undermine this trust. So far, despite the Fed originally being wrong about inflation, the Fed has done what it has said it would do. Stock and bond markets, which are a considerable part of the economy, have been slow to understand the Fed’s resolve.

It has been implementing the balance sheet run-off plan and raising rates toward a level it believes would equate to a future 2% inflation rate. Like so many other things in the social sciences, widely held expectations of the future become self-fulfilling.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.wsj.com/articles/move-over-inflation-here-comes-the-earnings-crunch-11668300124?mod=article_inline

https://www.wsj.com/articles/fed-raises-interest-rates-for-first-time-since-2018-11647453603?mod=article_inline

https://www.wsj.com/articles/feds-aggressive-rate-hikes-are-a-game-changer-11669006579?mod=economy_lead_pos5

www.BLS.gov

Why the Bullish Behavior of the Past May Return

Posted on by phoffman@channelchek.com
Philippe Petit walks Tightrope between buildings one and two of WTC, Manhattan, 1974 – Robert.Dearie (Flickr)

Analyst Team Point Out Asset Classes that Slingshotted in the 1970s

While the traditional fine print usually says, “past performance is no guarantee of future results,’ we all know trading decisions, whether the stocks are to be held for seconds, or decades, are based on probabilities. And market probabilities are rooted in past performance. What does past performance tell us about the chances that the markets can survive high inflation and low growth? Well, if the stagflation of the 70s repeats, there may be a small section of the markets to keep a solid footing.

Michael Hartnett is the chief investment strategist at Bank of America/Merrill Lynch. Hartnett sees in our current economy the ingredients in the macroeconomic picture that lead to the difficult economic combination of high inflation and low growth. His team, in their Flow Show note on Friday, wrote:  “Inflation and stagnation was ‘unanticipated in 2022…hence $35 trillion collapse in asset valuations; but relative returns in 2022 have very much mirrored asset returns in 1973/74, and the 70s remain our asset allocation analog for 2020s.”

 If the conditions of the 1970s are being mirrored and we are creating a foundation similar to 1973/74, Hartnett and team have a list of assets that could springboard off the stagflation cycle.

The assets with potential include taking long positions in small-caps, value, commodities, resources, volatility, and emerging markets. The group also highlights the short positions that worked well in the 1970s, the note indicates these are larger stocks, bonds, growth, and technology.

Why Small-Caps

As it applies to the smaller companies, the note points out that stagflation persisted through the late 1970s, but the inflation shock had ended by 1973/74, when the small-cap asset class “entered one of the great bull markets of all-time.” The Hartnett team sees small-caps set to keep outperforming in the “coming years of stagflation.”

The current year-to-date status has the Russell 2000 small-cap stock market index (measured by iShares ETF) down 19.8% in 2022. At the same time, the Dow Industrials are down 11%, S&P 500 lost 21%, and the Nasdaq Composite gave back 33%.

The current state of the Fed and Chairman Powell is they continue to be adamant about tightening, Powell said he’d prefer to overdo withdrawing stimulus than do too little. He also knows that until the market believes this, his tightening efforts will have a lower impact.

The BofA team isn’t helping market expectations as they noted, despite Powell’s clear signal that the Fed isn’t ready to declare even a slight victory from its raising rates; the analyst team says, don’t give up on that pivot.

After tightening interest rates through 1973/74 amid inflation and oil shocks, the central bank first cut in July 1975 as growth turned negative, Hartnett points out. A sustained pivot began in December of that year, and importantly, the unemployment rate surged from 5.6% and 6.6% that same month.

The “following 12 months, the S&P 500 rose 31%. The note suggests the lesson learned is that job losses when they occur, will be the catalyst for a 2023 pivot,” said Hartnett and the team.

We’re not there yet. Today’s economic release on jobs showed the U.S. added a stronger-than-expected 261,000 jobs during October. This is a slower pace than the prior month’s 315,000 job gains but still shows the Fed can comfortably notch rates up more and continue reducing its balance sheet.

Take Away              

The team of analysts at BofA/Merrill Lynch, reporting to Michael Hartnett, drew conclusions from the stagflation and financial markets’ performance of the 1970s. They shared their thoughts in a research note with investors. Looking at past performance, their expectation is that the Fed will pivot away from aggressively raising rates when it begins to negatively impact job creation. At this point, many markets will have already reacted to inflation expectations and would then react to a more accommodative monetary policy.

The asset sectors to avoid or short are larger stocks, bonds, growth, and technology. The preferred sectors that, in past situations, have done well are small-caps, value, commodities, resources, volatility, and emerging markets.

Be sure to sign-up at no cost for small and microcap company research sent to you each day by Channelchek.

Paul Hoffman

Managing Editor, Channelchek

Source

https://www.morningstar.com/news/marketwatch/20221104397/the-next-big-thing-is-small-get-ready-for-some-bullish-history-to-repeat-with-these-stocks-says-bofa-analysts

Household Income That’s Subject to Taxes Declines Next Year

Posted on by phoffman@channelchek.com
Image Credit: JD Hancock (Flickr)

These Are the New Federal Tax Brackets and Standard Deductions For 2023

Now for the inflation good news. Thankfully, as it relates to federal income taxes, the IRS makes annual adjustments to certain tax provisions. Simply put, the higher the inflation, the more tax credit benefit, which includes tax credits and taxable wages adjusted downward. So, in addition to receiving much higher COLA increases on Social Security payments and earning an interest rate in excess of 9% on U.S. Savings Bonds, those making an income in 2023 are likely to see more take-home pay.

The IRS Numbers Are In

The IRS announced the 2023 inflation adjustments to the standard deduction and other tax provisions for the 2023 tax year. The adjustments affect 60 provisions in the tax code, and leave a few key provisions unchanged.

Highlights of Changes in Revenue Procedure 2021-38

The tax year 2023 adjustments described below generally apply to tax returns filed in 2024.  A higher level of details about these annual adjustments can be found in IRS Revenue Procedure 2022-38PDF.

The standard deduction for married couples filing jointly for tax year 2023 rises to $27,700 up $1,800 from the prior year. For single taxpayers and married individuals filing separately, the standard deduction rises to $13,850 for 2023, up $900, and for heads of households, the standard deduction will be $20,800 for tax year 2023, up $1,400 from the amount for tax year 2022.

 Marginal Rates: For tax year 2023, the top tax rate remains 37% for individual single taxpayers with incomes greater than $578,125 ($693,750 for married couples filing jointly).

The other rates are:

  • 35% for incomes over $231,250 ($462,500 for married couples filing jointly);
  • 32% for incomes over $182,100 ($364,200 for married couples filing jointly);
  • 24% for incomes over $95,375 ($190,750 for married couples filing jointly);
  • 22% for incomes over $44,725 ($89,450 for married couples filing jointly);
  • 12% for incomes over $11,000 ($22,000 for married couples filing jointly).

The lowest rate is 10% for incomes of single individuals with incomes of $11,000 or less ($22,000 for married couples filing jointly).

 The Alternative Minimum Tax exemption amount for tax year 2023 is $81,300 and begins to phase out at $578,150 ($126,500 for married couples filing jointly for whom the exemption begins to phase out at $1,156,300). The 2022 exemption amount was $75,900 and began to phase out at $539,900 ($118,100 for married couples filing jointly for whom the exemption began to phase out at $1,079,800).

 The tax year 2023 maximum Earned Income Tax Credit amount is $7,430 for qualifying taxpayers who have three or more qualifying children, up from $6,935 for tax year 2022. The revenue procedure contains a table providing maximum EITC amount for other categories, income thresholds and phase-outs.

 For 2023, the monthly limitation for the qualified transportation fringe benefit and the monthly limitation for qualified parking increases to $300, up $20 from the limit for 2022.

 For the taxable years beginning in 2023, the dollar limitation for employee salary reductions for contributions to health flexible spending arrangements increases to $3,050. For cafeteria plans that permit the carryover of unused amounts, the maximum carryover amount is $610, an increase of $40 from taxable years beginning in 2022.

 For tax year 2023, participants who have self-only coverage in a Medical Savings Account, the plan must have an annual deductible that is not less than $2,650, up $200 from tax year 2022; but not more than $3,950, an increase of $250 from tax year 2022. For self-only coverage, the maximum out-of-pocket expense amount is $5,300, up $350 from 2022. For tax year 2023, for family coverage, the annual deductible is not less than $5,300, up from $4,950 for 2022; however, the deductible cannot be more than $7,900, up $500 from the limit for tax year 2022. For family coverage, the out-of-pocket expense limit is $9,650 for tax year 2023, an increase of $600 from tax year 2022.

 For tax year 2023, the foreign earned income exclusion is $120,000 up from $112,000 for tax year 2022.

 Estates of decedents who die during 2023 have a basic exclusion amount of $12,920,000, up from a total of $12,060,000 for estates of decedents who died in 2022.

 The annual exclusion for gifts increases to $17,000 for calendar year 2023, up from $16,000 for calendar year 2021.

 The maximum credit allowed for adoptions for tax year 2023 is the amount of qualified adoption expenses up to $15,950, up from $14,890 for 2022.

Brand New for 2023

The Inflation Reduction Act extended some energy-related tax breaks and indexed for inflation the energy-efficient commercial buildings deduction beginning with the tax year 2023. For 2023, the applicable dollar value used to determine the maximum allowance of the deduction is $0.54 increased by $0.02 for each percentage point by which the total annual energy and power costs for the building are certified to be reduced by a percentage greater than 25 percent (but not above $1.07). The applicable dollar value used to determine the increased deduction amount for certain property is $2.68 increased (but not above $5.36) by $0.11 for each percentage point by which the total annual energy and power costs for the building are certified to be reduced by a percentage greater than 25 percent.

Items Unaffected by Inflation Indexing

By statute, these items that were indexed for inflation in the past are currently not adjusted.

The personal exemption for tax year 2023 remains at 0, as it was for 2022, this elimination of the personal exemption was a provision in the Tax Cuts and Jobs Act.

 For 2023, as in 2022, 2021, 2020, 2019 and 2018, there is no limitation on itemized deductions, as that limitation was eliminated by the Tax Cuts and Jobs Act.

 The modified adjusted gross income amount used by joint filers to determine the reduction in the Lifetime Learning Credit provided in § 25A(d)(2) is not adjusted for inflation for taxable years beginning after December 31, 2020. The Lifetime Learning Credit is phased out for taxpayers with modified adjusted gross income in excess of $80,000 ($160,000 for joint returns).

What Else is Impacted

The maximum contribution amount for a 401(k) or similar workplace retirement plan is governed by yet another formula that uses September inflation data. It is estimated that the contribution limit will increase to $22,500 in 2023 from $20,500 this year and the catch-contribution amount for those age 50 or more will rise from $6,500 to at least $7,500.

The child tax credit under current law is $2,000 per child is not adjusted for inflation. But the additional child tax credit, which is refundable and available even to taxpayers that have no tax liability, is adjusted for inflation. It is expected to increase from $1,500 to $1,600 in 2023.

For those that look forward to capping out payments to Social Security, there is bad news. This has also increased. According to the 2022 Social Security Trustees Report, the wage base tax rate is projected to increase 5.5% from $147,000 to $155,100 in 2023.

Costs are rising, but so are deductions. It’s improbable that the reduced taxes will offset skyrocketing inflation, but at least there is one financial category that is helped by the increases.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2023

Benefits Increasing With COLA

Posted on by phoffman@channelchek.com
Image Credit:  401(k) 2012 (Flickr)

Soaring Inflation Prompts Biggest Social Security Cost-Of-Living Boost Since 1981 – 6 Questions Answered

Social Security is set to boost the benefits it provides retirees by 8.7%, the biggest cost-of-living adjustment since 1981. It comes as sky-high inflation continues to eat into incomes and savings.

The changes are set to take effect in January 2023 and were announced following the release of the September 2022 consumer price index report, which showed inflation climbing more than expected during the month, by 0.4%.

The automatic adjustment will surely come as a relief to tens of millions of retirees and those who receive supplemental security income who may be struggling to afford basic necessities as inflation has accelerated throughout 2022. But an annual adjustment wasn’t always the case – and other government benefits and programs deal with inflation differently.

John Diamond, who directs the Center for Public Finance at Rice’s Baker Institute, explains the history of the Social Security cost-of-living, or COLA, increase, what other benefits are adjusted for inflation and why the government makes these changes.

1. How fast is the cost of living rising?

The latest data, for September, shows average consumer prices are up 8.2% from a year earlier. The monthly gain of 0.4% was double what economists surveyed by Reuters had expected.

More troubling, so-called core inflation – which excludes volatile food and energy prices – gained even more in September, ticking up by 0.6%. Core inflation is a measure that’s closely watched by the Federal Reserve, as it helps show how pervasive and persistent inflation has become in the economy.

2. How are Social Security benefits adjusted for inflation?

Automatic adjustments to Social Security benefits began in 1975 after President Richard Nixon signed the 1972 Social Security amendments into law.

Before 1975, Congress had to act each year to increase benefits to offset the effects of inflation. But this was an inefficient system, as politics would often be injected into a simple economic decision. Under this system, an increase in benefits could be too small or too large, or could fail to happen at all if one party blocked the change entirely.

Not to mention that with the baby boomers – those born from 1946 to 1964 – entering the labor force it was already clear that Social Security would face long-term funding issues in the future, and so putting the program on autopilot reduced the political risk faced by politicians.

Since then, benefits have climbed automatically by the average increase in consumer prices during the third quarter of a given year from the same period 12 months earlier. This is based on a version of the consumer price index meant to estimate price changes for working people and has been rising slightly faster than the overall pace of inflation.

While helpful, these inflation adjustments are backward-looking and imperfect. For example, 2022 Social Security benefits increased by 5.9% from the previous year, even though inflation throughout this year has been significantly higher – which means the higher benefits weren’t covering the higher cost of living. Thus, the 2023 increase in benefits primarily offsets what was lost over the previous year.

A white hand holds a card reading social security

Millions of retirees and other will soon see a big jump in their Social Security benefits. AP Photo/Jenny Kane

3. Are the benefits taxable?

A growing portion of Social Security benefits are taxed in the same way as ordinary income, except at different threshold with various caps and percentages. Only 8% of benefits were subject to taxation in 1984, but that’s climbed to almost 50% in recent years. That percentage will likely continue to increase as the taxable thresholds are not adjusted for inflation.

For example, if an individual filer’s income, including benefits, is below US$25,000, none of that is taxed. But up to 50% of a person’s benefits may be taxed at incomes of $25,000 to $34,000. After that, up to 85% of their benefits may be taxed.

Such a big increase in Social Security benefits likely means some people who paid no tax will now have to pay some, while others will see larger increases in their tax liability.

4. Why does the government adjust benefits for inflation?

Rapid gains of inflation, like the kind the U.S. and many other countries are currently experiencing, can have significant impacts on the finances of households and businesses.

For example, it might mean seniors cutting back on heating or food. Government policies generally try to account for this to reduce the negative impacts that rising prices can have on those with limited or fixed resources.

In addition, reducing the impacts of price changes creates a more efficient and fair allocation of resources and reduces the arbitrary outcomes that would otherwise occur.

5. What other government programs typically get a COLA?

Other government programs and benefits also increase to account for inflation.

The U.S. Department of Agriculture estimates the cost of its Thrifty Food Plan each June and adjusts Supplemental Nutrition Assistance Program or SNAP benefits – formerly known as food stamps – in October of each year. Beginning in October 2022, food stamp benefits rose by 12.5%, which helps make up for the largest increases in food prices since the 1970s.

In addition, the federal poverty level is adjusted for changes in the consumer price index annually by the Department of Health and Human Services, an adjustment that affects a number of government-provided benefits, such as housing benefits, health insurance and others, including SNAP benefits.

6. Does the tax system also adjust for inflation?

While some aspects of the tax code adjust for inflation, others do not.

For example, income tax bracket thresholds, the size of the standard deduction, alternative minimum tax parameters and estate tax provisions all increase annually for inflation. That means come tax filing season next year, U.S. tax filers will likely see big changes in all these items.

But examples of provisions that are not adjusted for inflation include the maximum value of the child tax credit and the $10,000 cap on the deduction of state and local taxes. In addition, the threshold that determines who is liable for the net investment income tax – the additional 3.8% tax on investment and passive income for taxpayers above a certain income level – doesn’t adjust, which means each year more individuals are subject to it.

 This article was republished with permission from The Conversation, a news site dedicated to sharing ideas from academic experts. It represents the research-based findings and thoughts of  John W. Diamond, Director of the Center for Public Finance at the Baker Institute, Rice University.

When PPI and CPI are Correlated, and When they are Not

Posted on by phoffman@channelchek.com
Image Credit: Cottonbro (Flickr)

The Connection Between Producer Price (PPI) and Consumer Price (CPI) Inflation

Does a higher PPI mean a higher CPI? A newly released report shows U.S. suppliers raised prices by 0.4% in September from August, when the Producer Price Index report had shown a 0.2% drop. The inflation measure that has impacted the stock market most severely this year is the Consumer Price Index. The two Bureau of Labor Statistics (BLS) releases are related but not directly correlated and are often used to measure different things by economists and those in industry.

The PPI rose 8.5% in September from a year before, down from its 8.7% annual increase in August and 11.3% in June. – BLS

How CPI and PPI are Different

The PPI for personal consumption includes all marketable production sold by U.S.-domiciled businesses for personal consumption. The majority of the products sold by domestic producers come from non-governmental sectors. However, government produces some marketable output that is under the PPI umbrella. In contrast to the PPI’s components, CPI includes goods and services provided by businesses or governments when direct costs to the consumer are levied.

The most heavily weighted item in CPI is rent. It’s weighted at 24% of the index. What the BLS calls owners’ equivalent rent is the implied rent occupants would have to pay if they were renting their homes. This is how the Bureau of Labor Statistics captures the cost of housing for owner-occupied and rented housing. This heavily weighted component is not in PPI – obviously, owners’ equivalent rent is not a domestically produced output.

The PPI for personal consumption and the CPI also differ in their treatment of imports. The CPI includes, within its basket, goods and services purchased by domestic consumers and therefore includes imports. The PPI, in contrast, does not include imports because imports are, by definition, not produced by domestic firms.

How PPI Impacts CPI

The PPI trends often work their way into consumer price movements, but not at a one-to-one basis or even a standard delayed interval. The demand component of consumer’s impact, what the consumers are willing to consume at certain price levels, is at play with what is charged for goods at the retail level. So even if the cost to manufacture goods has risen, passing the cost on is not always possible without hurting sales. At some level of price increases, demand decreases. This is different for each type of product. For instance, food, medical care, and housing may not be impacted as much as recreation, clothing, and other items which are easier to put off or do without.

Companies are trying to manage higher costs without alienating consumers who are weary of price increases. So far in the 2022 U.S. economy, consumer spending has remained strong despite the rate of CPI, but economists worry that we’re approaching a tipping point.

The Fed has raised the benchmark federal funds rate at its last three meetings by 0.75 percentage points, it now sits in the range of 3% and 3.25%. Officials have indicated they are prepared to raise rates over the course of their final two gatherings this year to around 4.25%.

Today, with consumer inflation running at a four-decade high and savings measurements trending lower, consumers are expected to begin to change buying habits. This overall is bad for business and the economy, which is why the Federal Reserve is expected to continue its fight against price increases, despite their lack of popularity with the financial markets.

“Monetary policy will be restrictive for some time to ensure that inflation moves back” Fed Vice Chair Lael Brainard (October 10).

Prices have begun to fall for some goods and services, including commodities, freight shipping, and housing. Those declines have led some Fed watchers to warn that the central bank risks tightening financial conditions too much.

Take Away

Increases in producer prices are passed to consumers when they can be. However, there is only so much a consumer is willing to pay for a purchase they can put off or substitute for something cheaper. This has ramifications for investors.

Companies where demand will wain when prices rise, may find earnings weaken; these could include producers of discretionary goods. Stocks that are shares of consumer staple companies may not feel the brunt of consumer pushback; those that produce more cost-effective brands, including white label providers, may outshine their brand name competitors if consumers increase their substituting for lower priced alternatives. Health care is one area where demand changes little as prices change at the producer or consumer level.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.bls.gov/ppi/methodology-reports/comparing-the-producer-price-index-for-personal-consumption-with-the-us-all-items-cpi

https://www.wsj.com/articles/producer-prices-inflation-september-2022-11665541647?mod=hp_lead_pos2

New Data Indicates Inflationary Recession

Posted on by cpatches
Image Credit: Tom Fisk (Pexels)

Inflation Still Surprisingly Strong and Economy Weak

Two important numbers were released on the last day of September. One was based on old news but significant in its finality; it’s the final revision to GDP for the second quarter. The next is viewed as the Fed’s preferred inflation gauge, the PCE deflator. The final GDP number will make it more difficult for public officials or pundits to suggest we can avoid a recession in 2022, and the second did not give any hope that the Fed will have any reason to change course on tightening.

A Recession By Any Other Name

Gross domestic product (GDP) is the indicator that reflects the amount of output produced quarterly in a country. In the U.S., the Bureau of Economic Analysis (BEA) releases two estimates of quarterly GDP, known as the advance and preliminary estimates, in the two months before the release of the final number. So until the final number prints, the number GDP measure is subject to revision.

On September 30, 2022, the Final GDP report for the second quarter was released by the BEA. The report shows that GDP decreased at an annual rate of 0.6 percent in the second quarter of 2022 (table 1). This decline in economic output follows a decline of 1.6% in the first quarter of 2022.

Do two-quarters of a receding economy, based on GDP, indicate the U.S. is in the recessionary part of the business cycle? Most textbooks would agree with that definition. However, there is a Business Cycle Dating Committee within the National Bureau of Economic Research (NBER) that determines and labels where the nation is within the economic cycles; they have not made any declaration.

So far, in 2022, the economy has not experienced any economic growth. If the six months of contraction is eventually deemed an official recession, it will thus far have been a shallow one, characterized by strong employment.

Price Increases Higher than Expected

Inflation is still on many investor’s radar. The Fed is targeting reducing inflation to its 2% target. The inflation measure they use for this target is the PCE Deflator. That measure was released this morning, and it validates the aggressive actions being taken by the Federal Reserve. And suggests the Fed has a lot more work to do.

The personal consumption expenditures price index (PCE), which the Fed targets at 2%, rose 6.2% in August from a year earlier, the Commerce Department reported. Underlying inflation, as measured by a core reading that excludes food and energy prices, rose 4.9% from 4.7% previously.

These numbers are well in excess of the Fed’s target and seemingly trending upward. Expectations are the Fed will provide up to another 150 bp increase (1.50%) over the coming months. This would cause the Fed Funds rate to trade near 5%. There is nothing in today’s release that would likely cause expectations to change.

Stagflation?

High inflation and negative growth have many repeating the word “stagflation”. Stagflation has one more element missing, which is high unemployment. The current economic conditions in the U.S. include high demand for workers, this shortage actually helps feed into the inflation the Fed is trying to tame.

Take Away

The economy contracted slightly in the second quarter of 2022. The decline in production was smaller than measured during the first quarter. Federal Reserve policymakers saw one more reason to keep applying the economic brake pedal by taking money out of the economy, increasing upward rate pressures. The Fed caused rates to rise from 40-year lows faster than any time since the 1980s.

Stock market participants are factored into the Fed’s policy only to the extent that market moves may impact inflation or employment. The markets (stocks, bonds, real estate, gold) are negative on the year. There are some who suggest the Fed will use this as a signal to alter policy, if the Fed bowed to any of the markets listed here, the sign of weakness might actually cause a market collapse in stocks and bonds.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.bea.gov/news/2022/gross-domestic-product-third-estimate-gdp-industry-and-corporate-profits-revised-2nd

https://www.bea.gov/news/2022/personal-income-and-outlays-august-2022-and-annual-update

https://finance.yahoo.com/news/fed-seen-keeping-big-rate-131814754.html

https://www.stlouisfed.org/on-the-economy/2014/may/do-revisions-to-gdp-follow-patterns

https://www.learningmarkets.com/who-decides-when-we-are-in-a-recession

https://www.bls.gov/news.release/empsit.nr0.htm

September’s FOMC Meeting and Powell’s Unflinching Resolve

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Image Credit: Federal Reserve (Flickr)

The FOMC Votes to Raise Rates for Fourth Time

The Federal Open Market Committee (FOMC) voted to raise overnight interest rates from a target of 2.25%-2.50% to the new level of 3.00% – 3.25% at the conclusion of its September 2022 meeting. The monetary policy shift in bank lending rates was as expected by economists, although many have urged the Fed to be more dovish, others suggest the central bank is behind and should move more quickly. The early reaction from the U.S. Treasury 10-year note ( a benchmark for 30-year mortgage rates) is downward slightly, while the S&P sold off 26 points and the Russell 2000 remained unfazed. Equities later sold off as the Chairman held a press conference.

The statement accompanying the policy shift also included a discussion on U.S. economic growth continuing to remain positive. The FOMC statement said recent indicators point to modest growth in spending and production. Job gains were also seen as strong in recent months, and the unemployment rate remains low.

However, the statement points out that inflation remains elevated. The Fed believes this reflects supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures.

Russia’s war against Ukraine is causing tremendous human and economic hardship, according to the Fed. The statement indicated the inflation risks related to the is an area they are paying attention to.

Source: FOMC Statement (September 21, 2022)

The Federal Reserve made clear it was continually assessing the appropriate actions related to monetary policy and the implications of incoming information on the economic outlook. The Committee says it is prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede reaching the Committee’s goals. This is to include a wide range of information, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments, according to the statement.

Source: Federal Reserve Board and Federal Open Market Committee release economic projections from the September 20-21 FOMC meeting

Each member of the Federal Open Market Provides forward-looking assumptions on expected growth, employment, inflation, and individual projections of future interest rate policy. The table above indicates the range of expectations.

Take-Away

Higher interest rates can weigh on stocks as companies that rely on borrowing may find their cost of capital has increased. The risk of inflation also weighs on the markets. Additionally, investors find that alternative investments that pay a known yield may, at some point, be preferred to equities. For these reasons, higher interest rates are of concern to the stock market investor. However, an unhealthy, highly inflationary economy also comes at a cost to the economy, businesses, and households.

The next FOMC meeting is also a two-day meeting that takes place July 26-27. If the pace of employment and overall economic activity is little changed, the Federal Reserve is expected to again raise interest rates.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.federalreserve.gov/newsevents/pressreleases.htm

When Stocks Instead of TIPS are Better Hedges Against Inflation

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Image Credit: U.S. Dept. of Treasury

What’s the Best Inflation Fighter for Your Savings? Stocks or TIPS?

At a minimum, an investor with an eye toward having more, not less, in the future needs to beat the rate of inflation. Ideally, since the investor ties up their money, the buying power in their account should provide the current inflation rate plus a risk premium over the medium to long term. During the past few months, a number of long-term savers/investors have asked me what I thought about TIPS as a means of exceeding inflation. I have strong opinions on these Treasury securities. My thoughts are rooted in having been a portfolio manager for the country’s second-largest fixed income fund manager back in 1996 when the U.S. Treasury asked for our input on the design of the new bond. The Treasury wanted us to approve of the bonds enough to invest in them – in early 1997 I pulled the trigger on $100 million in the first ever TIPS auction – that was 25 years ago, and there is now enough data to compare the performance of Stocks, TIPS and the rate of inflation. Which one provides better inflation “protection”?

Some Details on TIPS

If you aren’t aware of the intricacies and history of the Treasury Inflation-Indexed Securities, dubbed TIPS, as the working name for the project back in 1996, here’s what you should know in a two paragraphs.

Interest rates were declining through the late 1990s and the Treasury Secretary Robert Rubin had a plan to lessen the government’s interest rate burden by issuing a bond with costs that would be lower with the declining inflation and interest rates. The Canadians, British, and Australians all had a bond type that floated with the countries’ inflation index. The Canadian-style bond had a fixed rate of interest where the principal accreted upward with an inflation index. On this new principal, an unaffected fixed-rate (coupon) would pay interest. The British and the Aussies paid the inflation addition with the coupon, the bondholder didn’t have to wait until maturity to be compensated for price increases. The U.S. adopted the Canadian system of accreting to principal.

The new bond was to be helpful to the U.S. Treasury, the conservative investor, and even the Federal Reserve. Inflation was sinking at the time, so investors were attracted in part to the idea that the securities effectively have a floor since the Treasury would never lower the principal accretion to below zero even if deflation became a problem. Retirees were told they should be thrilled to have a low-risk investment to choose from that paid inflation plus. The U.S. Treasury was looking forward to being able to reduce the interest costs of its debt as there were still bonds outstanding that were paying 14%. As for the Chairman of the Federal Reserve, Alan Greenspan, he was thrilled he’d have a constantly updating investor-driven mechanism that would indicate the market’s current expectation of inflation.

Inflation “Get Real”

Through the late seventies and into the early eighties, inflation was a big influencer on all household decisions. Durable items like washing machines were purchased sooner rather than later because they may cost much more later. Even borrowing to buy made good financial sense. As for investing or saving,  buying short bonds or CDs that always paid more than inflations and then reinvesting similarly when it came due provided the investor with a little more income than inflation (and sometimes a free toaster). The stock market had years where it had negative returns, but for the medium or long-term saver, it far exceeded inflation. This has not seemed to have changed. 

“Get Real” is a slogan that had been used by brokers trying to build enthusiasm for TIPS when they first came out. It refers to real yield, or put another way, the yield after inflation. TIPS were designed to pay the inflation rate plus an interest rate, so the investor earns a real yield. What no one anticipated when the securities were designed is the real yield could go negative, thus providing the investor with inflation minus whatever supply and demand decided.

The chart below demonstrates that over a recent 11-year period, TIPS paid negative real rates about a third of the time. They did not provide the investors with a return above the rate of inflation as originally envisioned.

Source: St. Louis Federal Reserve

Stocks are not designed to be correlated with the rate of inflation, but they generally do well when the economy is flourishing or expected to flourish (these periods tend to be associated with inflation). And equities fall off when there is a contraction or expectations of a bad business climate. The chart below uses the Russell 2000 Small-Cap Index as a measure of stock market performance. The period shown demonstrates that if one is looking to keep up with or beat inflation by any margin, Small-Cap stocks can be viewed as far superior to TIPS.

Source: Koyfin

During the period from August 2012 until August 2022, prices have risen a combined amount of 28.558%, according to a calculator provided by the Bureau of Labor Statistics. During the same period, an investment in TIPS provided 13.11% to the saver/investor. This equates to a real return of negative 15% over ten years. If the purpose of the investor is to keep up with and beat inflation, TIPS have failed as a decent option.

As for stocks, the downside over short periods has been much larger and deeper declines than TIPS. However, after year one, the declines were never large enough to show underperformance. TIPS failed its main goal of inflation plus. If an investor instead put money in small-cap stocks, they would have exceeded inflation by 110%.

While this is not predictive of the future, it is compelling evidence for anyone with a time horizon beyond a few years to look at the true risk profile of each. TIPS have performed worse than inflation. One reason for this is that bond prices have been held lower than the market would naturally have them because the Fed has taken so many on its balance sheet.

Take Away

The performance of the stock market over the medium to long term has a long history of beating returns of other assets, especially those of bonds. Treasury Inflation-Indexed Securities, the official name for the bond, does not have a “P” in it. The “P” was supposed to stand for “Protected.” Just prior to the first auction, the name was changed as government lawyers pointed out these may not protect the investor from inflation.

The Federal Reserve owns a third of the outstanding U.S. Treasuries, including a large allocation of TIPS.  This unnatural demand holds prices artificially below where the market would price them without the Fed’s impact. This skewing of the results would have been upsetting to former Fed head Alan Greenspan who felt the main appeal to the security was their ability to help predict future inflation.

Stocks have risks, and bonds have risks, if it’s inflation you’re looking to overcome, inflation-linked bonds have been historically off the mark.

Paul Hoffman Managing Editor, Channelchek

Sources

https://www.nytimes.com/1982/02/05/business/record-set-on-30-year-us-bonds.html

https://www.treasurydirect.gov/instit/annceresult/tipscpi/tipscpi.htm

https://www.bls.gov/data/inflation_calculator.htm

https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm

How New Technology Reduces Inflation Data

Posted on by cpatches
Image Credit: Kanesue (Flickr)

Why Apple Can Hold the Line on iPhone Prices and Keep Getting Relatively Cheaper

Inflation in the U.S. is surging to near a 40-year high, with prices on food, fuel and pretty much everything seeming to rise more every month.

Smartphones may be an exception.

Apple, for example, recently announced its new versions of the iPhone and other gadgets, and turned a lot of heads when it said it wouldn’t charge more despite higher costs to make the devices.

This is puzzling because companies typically raise prices in line with inflation – or at least enough to cover the increased costs of making their products.

Consumer price data tells an even more befuddling story. The latest consumer price index data suggests smartphone prices are actually down 20.4% in August from a year ago, according to an index released on Sept. 13, 2022. That’s the biggest drop of any detailed expenditure item the Bureau of Labor Statistics tracks, and contrasts with the overall 8.3% increase in prices.

What’s going on?

As an economist teaching business school students, I enjoy exploring and explaining these economic puzzles. I believe there are two basic explanations – one for the data and another for Apple.

Why Consumer Prices on Smartphones Fell

The story behind the consumer price index data is easier to explain, if a bit technical.

The 20% drop over the past year isn’t unusual for smartphones. In fact, according to the index, they almost always go down from month to month. Since the end of 2019, smartphone prices have come down a whopping 40%.

And though smartphones are showing the biggest drop in the index, tech gear more broadly – from computers to smartwatches – also tend to fall over time. In the previous 12 months, televisions are down 19% and what the government calls information technology commodities are down 8.8%.

Part of the reason for their steady decline is found buried in the Bureau of Labor Statistics website. The consumer price index tries to measure a constant quality of goods and services in the economy. This means it seeks to track the price changes of the exact same set of goods and services each month. It’s comparing the price today with the price of the exact same thing a month or year ago.

For most goods, it’s not really an issue because their quality doesn’t change much over relatively small periods of time. For example, an apple you bite into today is pretty much the same as an apple you ate a year ago.

Smartphones and other technology-heavy gadgets are different. Because smartphones are constantly improving in quality – with the latest updates of an iPhone or Samsung Galaxy awaited breathlessly every year – it is more difficult to ensure you’re comparing prices of products of the exact same quality.

For rapidly improving items, the Bureau of Labor Statistics uses what are called “hedonic regression models” to estimate these changes in quality over time. Hedonic models measure the same amount of satisfaction. While this sounds complicated, the goal is simple: to figure out how much each new smartphone feature changes the price.

As a consumer, you are essentially doing this whenever you decide whether it is worth paying the extra money for that marginally better camera or extended battery life when buying a new phone.

And so, the 20.4% drop doesn’t mean you’re going to pay less for a new smartphone. But it does suggest you’re getting 20% more bang for your buck versus the same phone a year earlier. Whether it’s worth it is another question.

Why Apple Kept Prices Flat

That brings us to why Apple didn’t change its prices, even as the quality of the iPhone improved and supply chain costs went up.

Beyond the quality issues, one of the main ways supply chain problems are affecting phones is in the shortage of computer chips. If there is any product dependent on computer chips, it is smartphones. The shortage has resulted in delays to produce cars, trucks and many other consumer items.

The shortage has also increased the price of semiconductor parts. The U.S. government’s producer price index shows the price of semiconductor parts like chips and wafers steadily rising since the COVID-19 pandemic began in 2020, after falling for years. Chip prices are likely going up 20% in the next year.

For these and other reasons, analysts were expecting Apple to increase its prices.

Instead, Apple released its latest iPhone models at the same prices as the last two models, or US$799 for the iPhone 14 and $999 for the pro version. Keeping prices constant during inflationary times means iPhones are getting relatively cheaper.

So why isn’t Apple increasing prices? Is it just being kind to its customers, who have fueled tremendous profits for the company over the past decade?

Probably not.

With a gross profit margin of over 40% – meaning that’s how much it makes over the cost of producing all its products and services – Apple can probably afford to absorb increased chip and other component costs.

My best guess, since the smartphone market is fairly competitive, is that Apple is keeping prices the same to build market share in the U.S. – beyond the record 50% it recently hit – so the iPhone remains one of the best-selling smartphones.

So while the cost of almost everything we buy is rising, you can take some comfort in knowing at least one item is getting both better over time and not succumbing to an inflationary price spiral.

This article was republished with permission from The Conversation, a news site dedicated to sharing ideas from academic experts. It represents the research-based findings and thoughts of Jay L. Zagorsky, Clinical associate professor, Boston University.