Category: Macroeconomics

Inflation and the actual cost of living

The misery index, the sum of unemployment and inflation, may understate misery because the cost of living to households and the affordability of key products are affected by myriad factors in addition to the rate of inflation.


Introduction:

Many analysts confound the concept of inflation and the cost of living.  Inflation is the change in the average price of goods and services in a basket of goods.   The cost of living is the total amount of money needed to meet basic expenses. 

The cost of living will increase with inflation, but this relationship is impacted by the way inflation is measured and other factors specifically loans and interest rates.

Economic or political arguments based on current and projected inflation numbers, which ignore other factors impacting the cost of living, often lead to specious conclusions. 

Often advocates of a particular policy argue that aggregate price indices either over or under state inflation to support their policy position.

  • An economist in a recent CNBC argued that the Federal Reserve Board should cut interest rates because the housing shelter cost component of the CPI provided a misleading estimate of housing cost increases.  (Saw on TV, sorry can’t find link.) 
  • Several economists, most notably the Boskin commission, argue a failure to adjust product prices for quality improvements has led to an overstatement of the CPI and inflation. 
  • Some politicians and economists have called for linking Social Security benefits to an alternative price index, which has a higher weight on health services.

Another major difference between inflation and the cost of living is that the later concept is substantially impacted by lending, loan terms, and interest rates while the former concept is exclusively based on prices of goods and services. 

This memo discusses the impact of different measures of inflation, cost of living and affordability on the current economic situation.

Analysis of components of the Consumer Price Index:

The measurement of three components of the CPI – shelter, health insurance, and advanced goods like computers – does not reflect the impact on affordability of these goods for many households.   

Shelter:    

The cost of shelter in the consumer price index, the single largest component (around one third of the basked of goods) is determined by  actual and imputed rents.

The use of imputed and actual rents to measure shelter costs makes more sense than the use of house prices because volatile asset prices increase wealth and inflation can decrease real wealth.  Actual shelter costs as measured by rent and imputed rent are sticky and tend not to fall, hence actual and imputed rent does track annual changes in costs. 

However, housing affordability, especially for first-time home buyers has fallen.  The Goldman Sachs housing affordability index (based on three factors household income, housing prices and mortgage rates) reached a record low in October 2022.  Recent research has documented the link between housing prices and homelessness.   Moreover, unaffordable housing situations has led to an increase in the number of people retiring with mortgage debt.  

Housing affordability may be more closely related to financial stress associated with high house prices than the shelter component of the CPI.

Health insurance: 

The CPI uses an indirect measure of health insurance premium inflation.   The CPI health insurance premium cost estimate is the portion of insurance premiums not used for medical 

Medical services and goods have a separate index.  

Most private health insurance in the United States is obtained through employers.  Typically, both the employer and employee pay a portion of the health insurance premium with the employee share varying across firms and changing overtime.  

The CPI price inflation index measures the combined cost of the health insurance to the employer and the employee.  It does not measure the cost to the household which is impacted by the employee share of the health insurance premium, the deductible and coinsurance and copay rates.   By contrast, a cost-of-living statistic would directly measure the amount households spend on their own insurance premium.  Note that an increase in total premiums will increase household expenses even if the employer share of the health insurance remains constant. 

Health plans require insured households to share in the cost of health expenditures with the share being determined by the deductible and coinsurance rates and other terms in the plan.  These health plan features also change over time and vary across firms.  A report by the Kaiser Family foundation founds the average general deductible of covered workers rose by 13 percent over the past five years and 68 percent over ten years.  The CPI does not account for the increased share of premiums paid for by households. A cost-of-living statistic would account for this shift.

Deductibles are not the factor impact the cost of health insurance for households.  Co-insurance rates define the portion of health expenses paid for by the household.  The in-network and out-of-network health coinsurance rate will often vary, and some health plans do not allow out-of-network service.  Coinsurance rates also differ for different types of services. Copayments are often charged for lab or doctor visits. The CPI does not account for any of these factors, but all of these factors impact the cost of health care and the cost of living.

The enactment of the Affordable Care Act allowed people to use a tax credit that is linked to income to purchase health insurance on state exchanges.  The total premium is linked to age.  It is higher for older people than younger people.  Many middle-income and upper-income people pay more for their health insurance under state exchanges than under employer-based plans because many employer-based plans pay a substantial share of the health insurance.  (Middle-income young adults could typically pay 100 percent of state exchange health insurance and around 30 percent of the premium of employer-based plans.) 

The CPI does not capture the increase in costs stemming from a shift towards state exchange health insurance.  A weighted average cost of living index would measure the higher cost imposed on some households.

Computers and other advanced goods:

Several products in the basket of goods used to calculate the CPI are adjusted for changes in quality via a hedonic price index.   The adjusted price used in the calculation of the aggregate price index and underlying inflation is lower than the actual price because the new computer or cell phone or software is better than the old one.    The theory is that the improved product causes increased productivity and utility, hence the higher price of the new product is not reflective of inflation.

One problem with this argument is that quite often the old product is unavailable, and consumers have no choice but to spend the actual price on the new product.  A replacement purchase is mandatory if new software does not work on the old device.

Second changing social norms can make the purchase of a new product unavoidable.  A cell phone is now almost mandatory for most people in the workforce.  The improved quality of the cell phone does not obviate the fact that it is now an essential product.

Third, some improvements in quality prove illusory.  Hertz is cutting back on its purchase of electric vehicles partially because of higher than expected repair costs.  EVs also have limited range. 

Fourth, increases in prices due to quality improvements lead to higher insurance costs.  Even if insurance prices remain constant, an increase in the amount of insurance purchased due to the higher price of the vehicle will increase the cost of living. 

It may be appropriate to adjust the CPI for quality improvements, but quality improvements don’t always lead to lower living costs.

The impact of debt and lending terms on the cost of living:

The CPI and inflation measures do account for the increased use of debt and alterations in the terms of debt on the cost of living.  

The largest impact of debt on living costs pertains to the increased use of student loans.  Debt per student has risen from $18,230 in 2007 to $37,650 in 2023.  This increase in debt is larger than the rate of inflation.  (Figures adjusted for inflation are $26,720 in 2007 to $37,650 in 2023.). The increased use of student debt will result in an increased use of unsubsidized student debt, which leads to higher total repayments because interest because the federal government makes interest payment on student loans while the student is in school. 

The average maturity of car loans, which is now near 70 months, has increased over time.

The CPI and measures of inflation do not account for higher living costs induced by increased debt and changes in the terms of debt.

Concluding Thoughts:

The misery index, the sum of the unemployment and inflation rate, suggests the economy is moving in the correct direction.  However, official inflation rates understate misery because changes in average prices do not measure all factors impacting the cost of living.

Authors Note:  Recent posts by David Bernstein include, The Case Against Medicare Advantage, An Interest Rate Forecast and Investment Advice, and Questions and Answers on IDR loans and the SAVE program.

An Interest Rate Forecast & Investment Advice

Even if the Fed pauses interest rates, especially the 10-year Treasury rate, will continue to rise. Focus on fixed-income investors should be on ladders with max maturity of two years.

Introduction:

Many analysts quoted in the popular press believe that interest rates have peaked, inflation is receding, the fed has tightened too far, and a recession is likely.

  • A July 7, 2022, a CNBC article suggested there was a high likelihood of a recession because of the inverted yield curve  (The 2-year T-bill rate was 4.9 percent and the 10-year rate was 3.9 percent at the time.)   
  • An October 6, 2023, Reuters article stated that a bear steepening of the U.S yield curve dashes ‘soft landing’ hopes.  (The 2-year interest rate is 5.1 and the 10-year rate is 4.7 at the time of the Reuters article.)
  • Analysts, in this CNBC article  anticipate Fed cutting interest rates and inflation receding in 2024.

The analysis presented here confirms that considerable increases in interest rates off their lows has occurred.  However, interest rates are by no means high compared to to historic figures. Moreover, the 10-year Treasury bond rate remains low relative to other interest rates and will continue to rise under the most realistic economic scenarios.

Some observations about interest rates:

Until recently, interest rates have been abnormally low and additional tightening while not immediately necessary could occur.

  • The median Fed Funds rate between 2011 and 2023 of 0.16 percent was far lower than the median Fed Funds rate of 5.50 between 1976 and 2010.
  • The current Fed Funds rate of 5.33 is close to the median Fed funds rate from the 1976 to 2010 period.
  • The Fed could go further if inflation accelerates.  The Fed funds rate went as high as 19 percent in 1981.

While Fed policy impacts interest rates, market forces also matter.  There is substantial disparity in recent movements of different rates.  In particular, the 10-year Treasury rate appears abnormally low compared to the Federal Funds rates and rates determined by the market.

  • The current two-year Treasury rate slightly above 5.0 percent is pretty close to the average two-year interest rate over the 1976 to 2023 period.
  • The current 30-year fixed rate mortgage of 7.89 percent is 21 basis points higher than the average over the 1976 to 2023 period.
  • The current 10-year Treasury interest rate of 4.71 percent is 118 basis points below the average over the 1976 to 2023 period.
  • The current differential between the 30-year fixed rate mortgage and the 10-year Treasury bond is 318 basis points.  By contrast, the average differential between 1976 and 2023 is 179 basis points.

Discussion:  The recent bear curve steepening is not over.  I expect the 10-year Treasury bond rate will continue to rise until it is in line with Fed policy and rates on other assets in the market.

My most likely economic scenario assumes the Fed will pause but not cut rates and that inflation will remain near its current levels.  The following recommendations are based on this outlook.

  • Continue to eschew the purchase of long-term bonds and bond funds without a fixed maturity date.
  • Focus most fixed-income assets in a bond/CD ladder with a maximum maturity of two years.
  • Allocate a small portion of the fixed-income portion of the portfolio to agency debt with a maturity of five years.
  • Continue purchasing Series I Savings bonds.

This strategy is premised on the view that inflation remains stable near current rates and the 

Fed pauses rate increases.  This scenario is more likely than additional Fed tightening, a soft landing and a hard landing into an immediate recession.

My next macroeconomic post will be on the likely of higher wage-push inflation and its impact on the economic outlook.  

Authors Note:  The author, an economist, is planning to publish and market a quarterly economic outlook.  He is available for economic and financial consulting projects.   His recent paper on the impact of student debt and additional education on household finances can be found here.  Also, please considering the kindle paper, A 2024 Health Care Reform Proposal.

The Debt-Limit Debate and Entitlement Spending

The Republican party is linking increases in the debt limit to cuts in entitlement spending. This approach will not lead to beneficial entitlement reform. A default on the debt would lead to catastrophic economic and political impacts. The 2023 fiscal debate should concentrate on how to phase out COVID-era relief benefits, instead of entitlement reform.


Introduction: 

A debt limit crisis that leads the United States to default on its financial obligations would be catastrophic. A U.S. debt default would lead to the demise of the dollar as the world’s reserve currency, increase interest rates, and reduce American influence abroad.  MAGA Republicans, who supported the insurrection and are supportive of Putin’s war in Ukraine, may not be opposed to these outcomes. 

GOP members of congress are threatening to refuse to support a debt-limit discharge unless the Senate and the President agree to cuts in Social Security.  Go here for some Republican ideas on linking increases to the debt limit to changes in Social Security and Medicare.  

The Debt Limit and Entitlements:

Many older people have very little in private retirement savings and are totally dependent on both Medicare and Social Security.  Efforts to change retirement and Medicare benefits must be preceded by reforms that decrease the number of older households with low levels of retirement assets or reserves for health expenditures.  

A proposal to increase the minimum age for Social Security benefits from 62 to 63 or longer would reduce the future debt to GDP ratio.  Financial markets are forward looking, hence the future expected debt to GDP ratio is a more important financial variable than current-year government deficits.  Entitlement reform should be more focused on the more important debt measure.

Immediate changes to entitlement spending would be detrimental to the economy, would reduce current consumption and would increase poverty among older households.

Reductions in entitlement spending cannot be implemented until after private retirement savings is increased, especially for households that currently do not save enough for retirement.

Efforts to expand private retirement savings will increase government deficits. 

Restrictions on government spending and tax expenditures for pension, health and other savings incentives stemming from a stringent debt limit will delay efforts to increase private retirement savings and will delay the needed increase in the retirement age.

The debt limit is not the only lever to force changes in entitlement spending.  The Trustees of the Social Security Trust fund project the trust fund will be depleted in 2035.  The projected depletion of the Trust fund will, under current law, lead to the automatic benefit cuts.   The avoidance of automatic benefit cuts, not the debt limit, is the best way to motivate actions on entitlement reform.

Concluding Thoughts:

Republicans do not have the votes for benefit reductions including changes in mean testing or increases in the retirement age.  Immediate changes in benefit formulas would be disastrous to current retirees and worker nearing retirement.  There is no support for MAGA-style entitlement reform in the Senate or in the current Administration.  The Democrats can’t link any entitlement change to a temporary increase in the debt limit because such an agreement would only lead to demands for additional changes in entitlements once the debt reaches the new limit. 

The 2023 fiscal discussion should center on efforts to reduce COVID-era emergency expenditures rather than efforts to force immediate changes in entitlement spending.  These debates will also be difficult and could lead to a government shutdown, an admittedly undesirable outcome but one that is less catastrophic than a default on the U.S. debt.  

David Bernstein, an economist living in Denver Colorado, is the author A 2023 Healthcare Reform Proposaland Alternatives to Biden Student Debt Relief Proposals. 

Should gig workers be employees?

A proposed Biden Administration rule reclassifying gig workers as employees, which intends to expand health and retirement benefits, would have adverse consequences. The proposed rule would reduce opportunities for people seeking flexible work hours, reduce employment options during economic downturns, cause some firms to reduce benefits, and worsen health insurance outcomes for some workers. Modifications to the tax treatment of individual retirement accounts and health insurance premiums would more effectively expand benefits than reclassification of work status.

Introduction:   A proposed Department of Labor rule, described here, would make it more difficult for companies to treat workers as independent contractors instead of employees. The proposal would classify workers as employees instead of independent contractors if they are economically dependent on a company. 

The purpose of the new rule is to increase health and retirement benefits for people currently employed as gig workers.   The proposed reclassification of gig workers to full-time employees does not automatically lead to better benefits for all workers and could have the unintended side-effect of decreasing opportunities in the labor force. 

  • Cost to firms maintaining current benefits packages would increase.
  • Some firms would reduce benefit packages to reduce the increase in costs stemming from the new regulation. 
  • Some firms would respond to the regulation by hiring fewer full-time employees and more part-time employees.
  • Some workers might leave the workforce because they would be unable to obtain employment offering flexible hours. 
  • Some workers with state-exchange health insurance would lose access to a premium tax credit and could receive a less generous health insurance package from their employer.

The reduction of disparities between the retirement and health benefits received by gig workers and employees could better be achieved through modifications of the tax treatment and rules governing health insurance premiums and individual retirement accounts than by the proposed regulation.  

Labor Market and Macroeconomic Issues:  

Supporters of the gig economy point out that many workers need or prefer a position that offers flexible hours.  This need is especially pronounced for people with young children.  Lack of affordable and reliable day care and was the cause of a decrease in workforce participation during the pandemic.  The forced reclassification of gig workers to employee status could reduce available flexible positions.

The existence of the gig economy may reduce loss of employment during recessions, if people who lose full-time traditional employment can find work in the gig economy.  One recent article explored the relationship between county unemployment and the proportion of county residents working online at a particular platform.  The article found that a 1.0 percent increase in county unemployment is associated with a 21.8 percent increase in the number of county residents working on-line at the platform.  This finding suggests that new regulations that reduce access to the gig work option could increase unemployment during a recession.

Health Insurance Issues:

Most working-age employees and their dependents obtain their health insurance from their employer and many employers pay a substantial portion of the health insurance premium.    Since the enactment of the Affordable Care Act, workers without an offer of employer-based insurance are eligible for a premium tax credit for health insurance on state exchanges.  The employer mandate, created under the Affordable Care Act, fined firms with more than 50 employees that did not provide health insurance to their full-time workers. 

The reclassification of gig workers as employees would reduce the role of state-exchange markets.  There is substantial disparity in the cost and quality of employer-based insurance.

In some cases, the reclassification of a gig worker to employee status will improve health insurance outcomes.  In other cases, the converted gig worker would have worse or more expensive insurance.

The reclassification of gig workers to employee status could benefit young middle-income workers with no dependents when employers pay a large share of premiums.  Many young adults receiving their health insurance on state exchanges pay 100 percent of their health insurance premium because the premium tax credit is not available when premiums are less than 8.5 percent of income.  These workers would realize lower insurance costs if they were reclassified as employees and if their new employer paid a share of the health insurance premium.

In other cases, the reclassification of gig workers to employees worsens outcomes.  Many employers offer only one health insurance plan with limited benefits, narrow networks, and high premiums for workers.  The existence of the offer of employer-based health insurance makes employees ineligible for the premium tax credit and makes state-exchange insurance unaffordable. 

A regulation leading to the reclassification of gig workers to full-time worker would cause firms that do not change their health insurance or employment policies to either increase purchase of health insurance for workers or pay a fine for full-time workers who receive their health insurance from state exchanges.  

Some firms would respond to the regulation by reducing hours worked, by increasing the number of part-time employees, thereby decreasing fines under the employee mandate.   Some firms would reduce insurance costs by increasing plan deductibles or by adopting a narrow health provider network.  Some firms would reduce the amount of their premium subsidy.

A better way to assist workers in the gig economy is to expand and improve subsidies for premiums on health insurance purchased on state exchanges while merging the markets for employer-based and state exchange insurance.  Three reforms that deserve consideration are:

  • Provide tax incentives for employer subsidies of state exchange health insurance instead of employer subsidies of firm-specific employer-based health insurance.
  • Modify the premium tax credit to provide some subsidy for young adults without an employer subsidy.
  • Create a new employer mandate consistent with the new subsidies.

The modified health insurance subsidy outlined here reduces costs of state exchange health insurance for all young adults who do not currently receive a subsidy.

The merger of state-exchange health insurance and employer-based health insurance markets and the modification of the premium tax credit will assist workers with multiple part-time jobs and will allow workers to maintain continuous health insurance coverage through periods of unemployment and job transitions. 

The merger of state-exchange and employer-based health insurance markets allows all households to search for the most suitable health insurance plan.  It prevents a situation where a worker needs specialized care perhaps at a top cancer hospital is tied to a single employer-based plan that does not offer access to the desired provider.

A more complete discussion of this health care reform proposal can be found here.   

Retirement Plan Issues:   

Many firms offer full-time employees a 401(k) plan.  Workers at firms that do not offer a 401(k) plan and gig workers must save for retirement through an Individual Retirement Account.

401(k) plans are more generous to employees than IRAs.  First, employers are allowed to directly contribute to a 401(k) plan and/or match employee contributions to the plan but are not similarly allowed to contribute to a worker’s IRA.  Second, the maximum allowable employee contribution to a 401(k) plan in 2022, ($20,500 or $27,00 if over 55 years old), is substantially higher than the maximum allowable contribution to an IRA, ($6,000 or $7,000 if over 55).

The reclassification of gig workers to employee status could lead to higher costs for firms and firms could take actions to offset the increase in costs.

Some firms will respond to reclassification of gig workers by reducing the number of workers who are eligible for participation in the firm-sponsored retirement plan.  This could occur by increasing the share of employees working part time.

Some firms could reduce employer contributions to 401(k) plans or eliminate the 401(k) plan altogether.

An alternative superior way to expand retirement benefits for gig workers is to increase the generosity of Individual Retirement Accounts and to allow firms to contribute to individual retirement accounts owned by employees and accounts owned by contractors.  Specific changes that should be implemented include.

  • Allow firms to directly contribute matching funds to Individual Retirement Accounts for employees and for independent contractors. 
  • Increase allowable worker contribution limits into Individual Retirement accounts to the level that exist for 401(k) accounts. 
  • Replace tax exemptions and deductions for Individual Retirement Account contributions with a tax credit.

The use of a tax credit for contributions to an Individual Retirement Account favors low-income workers who are in a lower marginal tax bracket.   The change from a tax deduction to a tax credit will also disproportionately benefit gig workers who tend to be in a low marginal tax bracket. 

Contributions to Health Savings Accounts are also tax deductible. Distributions from health savings accounts used for qualified health expenses are not taxed. The replacement of a tax deduction with a tax credit for contributions to health savings accounts would benefit low-income workers and could also disproportionately benefit gig workers.   Firms should also be allowed to make direct contributions to health savings accounts owned by employees and independent contractors.

The pension reforms currently being considered by Congress, discussed here, appear to increase the role of 401(k) plan and could exacerbate the gap between gig and employee pension outcomes.  Congress is not currently moving towards the pension reforms outlined in this memo.

Concluding Remarks: The typical gig worker receives less in health and retirement benefits than the typical employee.  However, the newly proposed rule that would convert gig workers to full time employees is an economically inefficient solution to this disparity.  The new rule would reduce the availability of positions with flexible work hours, reduce labor force participation among parents with young children, and could worsen unemployment during economic downturns.  The rule would result in many firms reducing health and retirement benefits.  Also, some gig workers that lose access to the premium tax credit for state exchange health insurance could be made worse off depending on the quality of the employer-based health plan received after reclassification.

A better solution to the disparity between health and retirement benefits offered to gig workers and full-time employees could be achieved through modification of rules governing health insurance premiums and rules governing Individual Retirement Accounts.

Should the Fed Pivot?

Short Answer is no. Interest rates have been artificially low for 15 years and remain below historical averages. The long era of artificially low interest rates created a bubble that was unsustainable. It is this bubble leading to a financial collapse, not Fed tightening, that will lead to an economic downturn.

Some perspective:

The Federal Reserve Board is supposed to be above political pressure.  That tradition along with several others died in the Trump era.  Remember when Trump was actively considering firing Powell.  More recently, it was Senator Warren that argues that Powell wants to throw Americans out of work even though the unemployment rate remains at 3.5 percent.

The other source of political pressure is from market participants, both participants in bond and equity markets who are used to low interest rates.   The taper tantrum of 2013 occurred when the fed announced it was going to gradually reduce asset purchases. Today the pressure is on the Fed to pivot and halt increasing rates.  Famous Fund manager Cathie Woods now writes that Fed tightening can lead to a deflationary post.  

Recession is possible but deflation is not a credible concern.  Substantial inflation now exists and will not go away soon. The economy would be much better off now if Powell had ignored Trump’s threats in 2018 and had recognized that inflation in 2022 was not transitory. 

The primary cause of the coming recession is not Fed tightening.  It is instead the collapse of a stock bubble that was the result of excessive monetary growth.    This bubble and collapse could have been prevented if the Fed had previously ignored Wall Street whims.

Analysis:  Interest rates are not high compared to past figures, especially given the level of inflation.  

The first set of figures for the 1-year and 10-year constant maturity bond rate and inflation cover the 1953 to 2022 period.

  • The current October 2022 one-year constant maturity rate is 8 basis points below the 1953 to 2022 median.
  • The current October 10-year constant maturity rate is 106 basis points below the 1953 to 2022 median.
  • The current inflation rate is 583 basis points above the 1953 to 2022 median.

The fact that the interest rates are low compared to historical figures when inflation is high is remarkable because borrowers generally require an interest rate that compensates them for inflation.

The second set of figures involves comparisons of current rates to the 1971 to 2023 median.  The shorter more inflationary period allows for inclusion of the 30-year mortgage rate.

  • The current rate is 356 basis points lower than the median for the 1-year bond, 469 basis points lower for the 10-year bond, and 315 basis points lower for the 30-year fixed rate mortgage, even though the current inflation rate is 287 basis points above the median.

Interest rates did rise quickly in 2022 primarily because rates were at such an artificially low level.  I compared actual September 2022 interest rates to predicted interest rates generated by a simple distributed lag model.   

  • The one-year interest rate rose a bit more than expected by the model.  The actual one-year rate was 3.9.  The predicted rate was 2.9.
  • The actual 10-year bond rate of 3.52 percent was very close to the predicted rate of 3.45 percent.

Concluding Remarks:  Interest rates are still below their historical medians.  When I look at likely interest rate outcome based on inflation and future inflation expectations, I see greater likelihood of higher inflation leading to higher interest rates and capital losses on bonds than interest rate declines and gains in bond prices.  

A Federal Reserve Policy pivot would increase my concern about higher inflation and interest rates.

I am not optimistic that the Fed Policy will lead to a soft landing, because inflation over the next few years may be driven by wages and low labor force participation, which could best be addressed by a more lenient immigration policy and tax incentives encouraging work.  

Authors Note: 

David Bernstein is the author of two recent policy memos.  One memo examines alternatives to the Biden Student Debt Plan. The memo argues that Biden’s student debt forgiveness plan and expansion of Income Based Replacement Loans will prove ineffective.  Several alternative policies including elimination of debt for first-year students, policies that promote on-time graduation, and interest rate concessions coupled with more stringent collection efforts on older loans near maturity are proposed and analyzed.

Another memo, A 2024 Health Care Reform Proposal , considers substantive health insurance reform.  The policies proposed here include ideas to provide continuous health insurance coverage during job transitions, improvements to health savings accounts, the elimination of short-term health plans, and a proposal to address problems caused by narrow-network health plans.

David Bernstein is also the author of eight personal finance memos contained in Financial Decisions for a Secure and Happy Life.  The book provides guidance on a number of topics including the choice between saving for retirement and reducing student debt, the choice between traditional and Roth retirement accounts, ways to minimize loss of retirement income from high-fee 401(k) plans and the advantages of the use of Series I Savings Bonds.  This $7.00 40-page memo could save you tens, even hundreds of thousands of dollars over a lifetime.

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 Three: The 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. 

Comparing traditional and chained CPI

Question:   What is the expected value of lifetime Social Security benefits for females and for males when benefits are linked to the traditional CPI and when benefits are linked to the chained CPI.

Discuss the reasons why women might prefer a switch to the chained CPI over proposals to partially privatize Social Security.

Short Answer:

Answer is contingent on several assumptions laid out below.  I find that changing from the traditional CPI to a chained CPI would reduce the expected value of lifetime Social Security benefits by around $16,000 for males and $21,000 for females.

The actual impact is invariably different from the expected impact.  Regardless of gender, people with the longest life span get the most from Social Security.

However, Social Security is really essential for females because private annuities are more expensive.  See my previous post on this topic.

http://dailymathproblem.blogspot.com/2014/01/gender-differences-in-life-expectancy.html

Analysis:

Key assumptions:

The key assumptions in this analysis are

  1. Person retires at age 62 and receives an initial Social Security retirement benefit of $15,000 per year
  2. Traditional CPI grows at 2.42% per year
  3. Chained CPI grows at 2.09% per year.
  4. In year of death person receives ½ year Social Security Benefit
  5. Probability of surviving from age 62 to age y> 62 is determined by the CDC life tables for females and males.

Readers interested in the discussion of assumptions on difference between traditional and chained CPI might want to look at this post.

http://dailymathproblem.blogspot.com/2014/02/comparing-traditional-and-chained-cpi.html

The expected lifetime Social Security benefit is E(SSB)=Sum(Pyr x CByr)  where Pyr is the probability of surviving to a particular year and CByr is the cumulative benefit from the retirement age at 62 to the year of death.

The logic behind the calculation of the probability a retiree survives to a specific date is similar to the logic behind the geometric distribution.   The probability of surviving to age y > 62 is the product of the probability of surviving to age y-1 and the probability of dying at age y.

Calculations:

The chart below has data on likelihood of surviving to age y+0.5 for males and females and the cumulative Social Security Benefit to age y+0.5 under both the existing COLA and a chained CPI COLA.

Survivor Probabilities and Cumulative Benefits
Age y Probability of surviving to exactly age y+0.5 for males Probability of surviving to exactly age y+0.5 for females Cumulative Benefit With Existing COLA Cumulative Benefit With COLA linked to chained CPI
62 0.01321 0.00831 $7,500 $7,500
63 0.01405 0.00896 $22,682 $22,657
64 0.01496 0.00965 $38,230 $38,130
65 0.01599 0.01044 $54,156 $53,927
66 0.01713 0.01133 $70,466 $70,054
67 0.01830 0.01227 $87,171 $86,518
68 0.01946 0.01322 $104,281 $103,327
69 0.02062 0.01422 $121,805 $120,486
70 0.02178 0.01526 $139,752 $138,004
71 0.02306 0.01647 $158,134 $155,889
72 0.02458 0.01783 $176,961 $174,147
73 0.02620 0.01929 $196,244 $192,786
74 0.02780 0.02077 $215,993 $211,816
75 0.02935 0.02224 $236,220 $231,243
76 0.03079 0.02380 $256,936 $251,076
77 0.03230 0.02547 $278,154 $271,323
78 0.03392 0.02732 $299,885 $291,994
79 0.03557 0.02926 $322,143 $313,096
80 0.03691 0.03112 $344,938 $334,640
81 0.03791 0.03288 $368,286 $356,634
82 0.03876 0.03473 $392,198 $379,088
83 0.03954 0.03677 $416,690 $402,011
84 0.03996 0.03858 $441,774 $425,413
85 0.04032 0.04017 $467,464 $449,304
86 0.04010 0.04170 $493,777 $473,694
87 0.03929 0.04275 $520,727 $498,594
88 0.03787 0.04322 $548,328 $524,015
89 0.03584 0.04302 $576,598 $549,967
90 0.03325 0.04209 $605,551 $576,461
91 0.03021 0.04041 $635,206 $603,509
92 0.02681 0.03798 $665,578 $631,123
93 0.02321 0.03490 $696,685 $659,313
94 0.01957 0.03128 $728,544 $688,093
95 0.01604 0.02730 $761,175 $717,474
96 0.01276 0.02314 $794,596 $747,469
97 0.00984 0.01903 $828,825 $778,091
98 0.00734 0.01513 $863,882 $809,353
99 0.00529 0.01163 $899,788 $841,269
100 0.01012 0.02606 $936,563 $873,851
1.00000 1.00000

The expected value of lifetime benefits for males/females under traditional/chained CPI is simply the dot product (the sum product function in EXCEL or NUMBERS) for the relevant probabilities and cumulative benefits.

Impact of Change in COLA by Gender
Males Females Difference Females- Males
Traditional CPI $392,077 $463,804 $71,727
Chained CPI $376,005 $442,772 $66,767
Difference Traditional-Chained CPI $16,072 $21,032

The change in the COLA formula from the traditional CPI to the chained CPI leads to a reduction in expected lifetime benefits of $16,000 for males and $21,000 for females.

Social Security still provides longevity protection under a chained CPI.

http://dailymathproblem.blogspot.com/2014/01/gender-differences-in-life-expectancy.html

This is especially important for females because of their longer life expectancy.

Concluding Thoughts:

The issue of the Social Security COLA is important and complex.   I am of the view that a change in the COLA could be part of a package of Social Security and retirement reforms.  Social Security reform must also encompass additional revenues and rule changes that eliminate future automatic cuts in Social Security benefits.   Pension reform must encompass improvements t0 401(k) plans and additional sources of low-cost annuity income.

Some readers might be interested in my views on the politics of the COLA debate.

http://policymemos.blogspot.com/2014/01/common-ground-on-social-security-colas.html

Impacts of shift from traditional to chained CPI on Social Security Benefits

Question: What is the potential annual impact and cumulative dollar impact of a policy change that links Social Security benefits to the chained CPI rather than the traditional CPI?

Assumptions:

Analysis presented here pertains to a single retiree who retires at age 62 with a $1,250 per month Social Security retirement benefit.

The traditional CPI grows at 2.42% per year.  The chained CPI grows at 2.09% per year.     These statistics were based on BLS data over the 1999 to 2013 time period.  Economists at the Bureau of Labor Statistics at the Department of Labor informed me that they did not have data on the chained CPI for years prior to 1999.

See the link below for statistics on the traditional and chained CPI.

http://dailymathproblem.blogspot.com/2014/02/comparing-traditional-and-chained-cpi.html

Analysis:  Information on the growth of the annual Social Security Benefits adjusted for the traditional CPI and adjusted for the chained CPI is presented for a retirement potentially spanning from age 62 to age 100 is presented in the table below.

In this table, the first column is age, the second column is the Social Security benefit adjusted by the traditional CPI, the third column is the Social Security benefit adjusted for the chained CPI, and the fourth column is the cumulative change in the Social Security benefit due to the adjustment process.

Path of Social Security Benefit With adjustment based on the traditional CPI Path of Social Security Benefits with Adjustment based on the chained CPI Reduction in Benefits for Age Due to Switch from Traditional to Chained CPI Cumulative Reduction in Benefits
$15,000 $15,000 $0 $0
$15,363 $15,313.50 $50 $50
$15,735 $15,633.55 $101 $151
$16,116 $15,960.29 $155 $306
$16,506 $16,293.86 $212 $518
$16,905 $16,634.41 $271 $788
$17,314 $16,982.06 $332 $1,120
$17,733 $17,336.99 $396 $1,516
$18,162 $17,699.33 $463 $1,979
$18,602 $18,069.25 $533 $2,512
$19,052 $18,446.90 $605 $3,117
$19,513 $18,832.44 $681 $3,797
$19,985 $19,226.03 $759 $4,557
$20,469 $19,627.86 $841 $5,398
$20,964 $20,038.08 $926 $6,324
$21,472 $20,456.88 $1,015 $7,338
$21,991 $20,884.42 $1,107 $8,445
$22,523 $21,320.91 $1,202 $9,647
$23,068 $21,766.52 $1,302 $10,949
$23,627 $22,221.44 $1,405 $12,355
$24,198 $22,685.86 $1,513 $13,867
$24,784 $23,160.00 $1,624 $15,491
$25,384 $23,644.04 $1,740 $17,231
$25,998 $24,138.20 $1,860 $19,091
$26,627 $24,642.69 $1,985 $21,075
$27,272 $25,157.72 $2,114 $23,189
$27,932 $25,683.52 $2,248 $25,437
$28,608 $26,220.31 $2,387 $27,824
$29,300 $26,768.31 $2,532 $30,356
$30,009 $27,327.77 $2,681 $33,037
$30,735 $27,898.92 $2,836 $35,873
$31,479 $28,482.01 $2,997 $38,870
$32,241 $29,077.28 $3,163 $42,033
$33,021 $29,685.00 $3,336 $45,369
$33,820 $30,305.41 $3,515 $48,884
$34,638 $30,938.79 $3,700 $52,583
$35,477 $31,585.42 $3,891 $56,475
$36,335 $32,245.55 $4,090 $60,564
$37,215 $32,919.48 $4,295 $64,859

Some observations:

  • The annual impact of the change from the traditional to chained CPI grows over time.
  •  The annual impact is $463, at age 70 $1,302 at age 80 at age 80, $2,532 at age 90, and $4,294 at age 100.
  • The cumulative impact of the change in the COLA formula is $1,979 at age 70,  $10,949 at age 80, $30,356 age 90, and $64,859 at age 100.

Some Implications:

  • The change from a traditional to chained CPI would have a very large impact both on household and national finances.
  • The fiscal impact of the change in the COLA formula would grow for 38 years until it reaches a constant rate.   (After 38 years the new COLA fully impacts all retirees based on their age.)
  • The change phases in slowly which gives people time to respond and change spending patterns.
  • The annual and cumulative impacts are largest for people near the end of their life when expenses both from increased medical needs and a need to change living arrangements are largest.

You may be interested in my policy blog on the Social Security COLA.

http://policymemos.blogspot.com/2014/01/common-ground-on-social-security-colas.html

Unemployment, Labor Force Participation, and the Government Deficit

Unemployment, Labor Force Participation and the Government Deficit

Issue:   The Chart below has data on three important economic variables – the unemployment rate, the labor force participation rate and the government deficit as a percent of GDP.   The unemployment and labor force participation rate variables are observed on three dates   — July 2009 (near the peak of the recession) January 2017 (the month of President Trump’s inauguration), and September 2009 (the most recent month at the time of this writing.

What does this data say about the recovery after the recession under President Obama?

What does this data say about the impact of President Trump’s economic policies on the labor market and on the government deficit?

How does information from the unemployment rate and information obtained the labor force participation rate differ regarding, evaluations of the economic records for Obama and Trump, an assessment of the current strength of the economy and projections of the likely path of debt to GDP?

Three Economic Variables
Unemployment Rate
Date Value
Jul-09 9.5
Jan-17 4.8
Sep-18 3.7
Labor Force Part. Rate
Jul-09 65.5
Jan-17 62.9
Sep-18 62.7
Government Deficit as % GDP
Date Value
FY 2009 -9.8
FY 2016 -3.2
FY2018 -4.2

Trends:

The unemployment rate fell from 9.5 percent during the recession to 4.8 percent at the end of President Obama’s term.

The unemployment rate has continued to fall under President Trump and is currently at 3.7%.   This is the lowest level since 1969.

The labor force participation rate was higher during the recession than at the end of President Obama’s term.

The labor force participation rate has not risen under President Trump despite the tax cut.

 

The government deficit fell from 9.8 percent of GDP in 2009 (recession year) to 3.2 percent in 2016 (last Obama year.)

The FY 2018 deficit as a percent of GDP is 4.2 percent, substantially higher than when President Obama left office.

Discussion:

An analysis of economic conditions and the labor market based on the unemployment rate alone would conclude that the job market and economy are red hot.   The unemployment rate has not been this low since 1969.  President Trump’s tax cut is one reason why the unemployment rate fell to its current level.

An analysis of the recovery from the recession and current economic condition incorporating information about the labor force participation rate, indicates the economy is not over heated.

Many critics of President Obama claimed that recovery was weak because the labor force participation rate remained very low.

https://freebeacon.com/issues/obama-economy-9-9-million-employed-14-6-million-left-labor-force/

The labor force participation rate is lower under President Trump than under President Obama.   President Trump’s economic policies have failed to increase the labor force participation rate.

President Trump’s economic policies have increased the government deficit as a percent of GDP.  The 2018 fiscal deficit is over 30 percent higher than the 2016 fiscal deficit.

Concluding Thoughts:

My view is that the LFPR has decreased due to population aging and further stimulus will not expand the workforce.  Moreover, the decrease in unemployment which coincided with the tax cut will not persist for much longer.   The loss of revenues from the tax cut will be larger in FY 2019, 2020 and 2021.   The budget deficit could be larger than 9 percent of GDP prior to the start of the next recession.

President Trump by reducing taxes and expanding deficits in a strong economy has weakened the ability of fiscal authorities to stimulate the economy when the next recession hits.

Authors Note:   I hope you will try my book

Innovative Solutions to the College Debt Problem:

https://www.amazon.com/Innovative-Solutions-College-Debt-Problem/dp/1982999446