How to Insulate Your Portfolio from Inflation

Annual limits on the purchase of Series I is more than $10,000 if you have a tax refund or some other entity like a Trust or business. Additional inflation protection can be obtained through the purchase of Treasury Inflation Protection Securities (TIPS).

Question: I am worried that my retirement plan will not keep up with inflation and would like to increase my holdings of Series I savings bonds.  However, there is a $10,000 annual limit on purchase of these assets. What can I do?

Answer:   The purchase of Series I savings bonds is the single best way to protect yourself and your household against inflation. Series I Bonds are literally the only thing working in most portfolios today, a situation that will unfortunately persist unless inflation drastically recedes.

The Treasury limits direct purchases of Series I Bonds from Treasury Direct to $10,000.  However, taxpayers with a tax refund can purchase an additional $5,000 in Series I Bonds. Go here for a discussion of how to do this.   You can also purchase Series I bonds through a Trust or a business.   The first step is to go to Treasury Direct and set up an entity account.

The annual limits prevent most households from quickly increasing their holdings of Series I bonds in response to a sudden shift in inflationary expectations.

Additional protection against inflation can be obtained by purchasing Treasury Inflation Protection Securities (TIPs). There is $10 million dollar limit on each TIPS security for each auction.  I am not worried about every being constrained by this limit.

The price of TIPS varies with interest rates and inflationary expectations, and you can lose money on TIPS. But price risk can be managed by staggering the purchase dates and maturity dates of the TIPS bonds and holding the bonds until maturity.

Series I Bonds are sold at par and never fall in value.    The semi-annual rate can go up and down with inflation, however, the bonds will not fall in value with inflation.  Go here for Series I FAQs from Treasury Direct.  Go here for a comparison of Series Bonds and TIPS.Authors Note:  The paper Financial Decisions for a Secure and Happy Life  is a collection of eight essays.  One of the essays provides a lot of information on Series I bonds and Tips.  The author has also written extensively on health care with his most recent paper outlining potential 2024 care reform proposals

The Likelihood of Higher Future Interest Rates

Despite recent tightening by the Federal Reserve Board, interest rates remain relatively low both compared to past decades and the current inflation rate. Persistent Inflation will lead to a long period of higher interest rates.


Introduction:

Some pundits believe inflation has peaked, and it is now time to buy bonds. These pundits offer an inaccurate macroeconomic assessment and bad financial advice.

Comment One:  The nominal 10-year Treasury interest rate is roughly where it was in February 2014, but inflation is substantially higher. 

Both in February 2014 and September 2022, the 10-year constant maturity interest rate was 3.4 percent.

  • In February of 2014, the one-year inflation rate was 1.6 percent. It had hovered close to that level for the entire year.
  • The reported inflation rate in August of 2022 was 8.2 percent up from 5.2 percent, 12 months early. 

People purchasing 10-year bonds are now earning far less than inflation.   We should expect this gap to narrow and bond yields to rise unless inflation suddenly plummets.

Comment Two:   Interest rate comparisons based over data from the last 10 or 15 years are deceptive because rates have been abnormally low.

Comparisons to average and high interest rates over a longer period are more relevant.

  • This graph shows the 10-year rate reached 5.0 percent in June 1967 and stayed above 5.0 percent until July 1998, literally 31 years.  The current 10-year rate is 3.5 percent.
  • This graph reveals that while the current two-year constant maturity rate is at its highest level since 2007, it is also lower than any rate that existed between 1976 and August of 2001.

Comment ThreeThe reduction in interest rates requires a decrease in inflation, an unlikely outcome in the near term

In a previous era, the Federal Reserve used two tools, higher interest rates and lower money supply, to reduce inflation.  Today the main tool is higher interest rates, which remain below historic levels.   

The money supply has grown robustly during the pandemic and is at a high level compared to the size of the economy.  The impact of past increases in the money supply on the price level has not been fully realized.  Whether the Federal Reserve Board can reduce the inflation rate without reducing the money supply is questionable.

Comment Four:  Wages are likely to continue to increase, even if there is a recession, leading to 

significant wage-push inflation over the next few years.  

There are many reasons why worker compensation is likely to continue to increase over the next few years.

  • One way to reduce the gap between job openings and people, noted here, is to increase immigration, an outcome that appears unlikely in the current political environment.
  • Many workers are burnt out from COVID and resistance to returning to the office can increase wages in some areas, especially for firms and industries dependent on in-person work.  
  • There is a shortage of teachers, nurses, airline pilots, long-haul drivers, and highly skilled computer analysts. These shortages won’t be instantly reversed with the advent of a recession.  The shortage of nurses guarantees that health care costs, a key component of both the CPI and workers compensation will not fall in the near or intermediate term.   
  • Some unions have recent won large increases in compensation, with a recent example being the rail unions.  Increases in rail transport prices will increase the price of transported goods.

The wage-push inflation will make it very difficult to reduce inflation and return to the abnormally low interest-rate environment.

Comment Five:  The housing component of the CPI will not fall with an increase in interest rates.

The housing price component of the CPI described here is based on imputed rents.  An increase in mortgage interest rates generally leads to higher observed and imputed rents.

The increase in interest rates will reduce the affordability of new mortgages and decrease house prices. However, relatively few households buy or sell a house in a particular year.   Increases in interest rates, which delay home purchases, can increase both actual rents and imputed rents used for the CPI housing cost calculation.

Increases in the housing cost component of the CPI, stemming from higher interest rates, will contribute to inflation despite a decrease in aggregate demand from higher interest rates.

Comment Six:  More supply shocks leading to more inflation are likely.

The most likely supply shock from the Ukraine war involves higher food prices from disruptions in grain and fertilizer exports.

Concluding Remarks:   How should investors respond to this economic outlook?

Avoid long-term bonds, anything with a maturity more than two years.

Avoid bond ETFs.  Even shorter maturity ETFs and ETFS that own TIPS bonds have been problematic over the last year.

Purchase at least $10,000 in Series I Bonds every year from Treasury Direct.  Additional purchases beyond the $10,000 limit are possible through tax refunds, trusts and S-corporations.  For details go to essay five here.

Allocate a small share of your wealth to two-year Treasury bonds.  The purchase and maturity dates of the bonds should be staggered to create constant liquidity when the bonds mature.  Ownership of bonds is preferrable to investments in bond ETFs because bonds return the initial investment at par value on the maturity date.

Authors Note:  David Bernstein is the author of eight essays published in Financial Decisions for a Secure and Happy Life

The Case for Rapid Repayment of Student Debt

New entrants to the workforce need to prioritize student debt reduction over contributions to 401(k) plans.

The first of eight essays in my new paper Financial Decisions for a Secure and Happy Life makes the case that new entrants to the workforce must often delay savings for retirement to quickly eliminate most if not all their student debt.  There are several reasons for this finding.

Reason One:  Failure to reduce student debt to a manageable debt level often leads to poor credit and higher borrowing costs on auto loans, credit cards, private student loans, and mortgages.

Reason Two:  A person using a short maturity loan will pay substantially less in interest than a person using a long maturity loan.

Reason Three:  The decision to enroll in an Income Driven Repayment loan and only pay the minimum balance will often result in increased loan balances and substantially higher lifetime interest payments. 

Reason Four:  The quick reduction of student debt frees up cash for other financial priorities including increased savings for retirement.

Reason Five:  Most young student borrowers choosing to immediately save for retirement on their first job will raid their 401(k) plan and pay tax and penalty.

Reason Six:  The rapid elimination of student debt facilitates the purchase of a first home, lower mortgage costs, and higher house equity, an important source of wealth. 

The succinctly written eight essays in  Financial Decisions for a Secure and Happy Life can be obtained for $7.00.  I suspect you will find the financial strategies and tips outlined there worth much more.

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  • Further modifications to the premium tax credit to reduce worker share of premiums for middle-income young adults without employer-based coverage.
  • Creation of new low-cost comprehensive health insurance plans combined with the elimination of current short-term health insurance plans.
  • Improvements in Health Savings Account for low-income and mid-income households. 
  • Creation of incentives leading to Increased access to top hospitals and specialists.

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