FED NOT DONE
Many on Wall Street and Main Street hoped the Federal Reserve finished raising interest rates when the July inflation report showed inflation slowing month-to-month. These numbers helped spur the stock market’s June rally well into August. But alas, such was not going to be the case.
At the Jackson Hole Economic Symposium, Federal Reserve Chairman Jerome Powell made it abundantly clear that the Fed still had to work aggressively to reduce inflation. The markets all dropped 3-4% immediately following the speech. It was an ugly day.
The Fed understands that if inflation gets embedded into the economy, we could find ourselves with a 70s style of inflation, resulting in even more damage to the economy than a recession next year. We expect the Fed to raise rates at least 50 basis points at the meeting later in September, and another 75 basis point hike is not off the table later in the year. With three more meetings remaining in 2022, the rate will likely be close to 4% by the end of the year. If the labor market remains strong, we should be able to weather the storm.
STUDENT LOAN FORGIVENESS
During then-candidate Joe Biden’s campaign, he pledged student loan forgiveness for most individuals with Federal student debt. Last week he made good on that promise and announced that anyone with less than $125,000 of income ($250,000 for a couple filing jointly) would have up to a $10,000 forgiveness in their student loan debt. For those who qualified for a Pell grant, outstanding debt would be reduced by up to another $10,000, for a total of $20,000 in forgiveness. Biden further suspended loan repayments, which were set to begin again in September, delaying them to the first of next year.
Under current rules, an individual must pay at least 10% of monthly discretionary income. Under the new rules that is being reduced to 5%. If you make less than roughly $30,000, you are not required to make payments for undergraduate loans. Further, those that make 10 years of payments (down from 20 years) and have a balance of $12,000 or less will have the rest of the loan forgiven.
These proposals set off a firestorm of protests from Republicans, Democrats, people with student loans, people who paid off their student loans, liberals, and conservatives. Why would so many disparate groups object? At the most basic level, many people find something wrong in just outright forgiving debt. Those who had already paid off their debt, or at least a substantial piece of it, were mad that others were getting a break. Those who didn’t borrow at all are upset because they didn’t get any help.
Many liberal Democrats, led by Senator Bernie Sanders, didn’t think the President did enough. Some from both sides of the aisle thought that shifting the burden to taxpayers was wrong and potentially inflationary. Fiscal hawks saw the estimated $300-500 billion forgiven over the next 10 years unnecessarily adding to the national debt. The Penn-Warton Business Model said the cost could be as high as $980 billion.
While touted as helping millions of middle-class Americans struggling with this debt, the Committee for a Responsible Federal Budget said that the top 10% in income gained more than the bottom 30%. While some Republicans said it was an election year gimmick for votes from young people and progressives, the whole thing might backfire given the number of people upset with the proposal.
HOW THE FED FIGHTS INFLATION
Did Albert Einstein say that compound interest is the most powerful force in the universe? Were he still alive today, we would rather ask him where he thinks the Fed ranks on this list of universal forces. As the central bank of the largest economy in the history of the world, the U.S. Federal Reserve System wields immense power that has a global (if not universal) impact on everything from housing, trade, and employment, even to the rate at which Einstein’s supposedly top pick wields its power.
The Fed has a dual mandate of price stability and maximum employment. It also regulates commercial banks, which must hold reserves at the Fed, and in times of crisis, acts as the lender of last resort. The Fed has several tools to achieve its dual mandate and it does so by adjusting the money supply, which in turn influences the federal funds rate. This is the rate that large banks charge each other to lend out excess reserves held at the Fed. It is one of the key lending rates that other loan and deposit rates are priced from and gives investors insight into the Fed’s view of the economy.
To increase employment and promote rising prices, the Fed targets a lower federal funds rate. The current environment of high inflation means prices have become unstable, forcing the Fed to target a higher federal funds rate that cools down the economy and lowers prices. The trick is to do so without tipping the U.S. (and likely the globe) into a recession. With such far reaching implications, investors and consumers alike are hoping the Fed uses its power carefully. For more on how the Fed raises interest rates and why, please see our latest video (link).
INFLATION REDUCTION ACT AND MEDICARE
While it will be debated for years whether this bill has any impact on inflation, it makes significant changes to prescription drug prices under Medicare. Congress intended to lower the cost of drugs and to reduce the amount a Medicare recipient would pay out-of- pocket when it added Part D for prescription drugs back in 2003.
The new act now caps total drug costs for those with Part D at $2,000 per year, beginning in 2025. That is a BIG deal for many seniors and will certainly help those that are reliant on expensive drugs. In another part of the bill, it limits the increase in drug costs to the annual inflation rate and if the cost rises more, the drug company will have to pay the government a rebate.
For the past few years, the cost of insulin has been part of the news cycle. Starting next year, insulin will be capped at $35 per month. Unfortunately, this cap only applies to Medicare and not to private plans.
One controversial part of the 2003 Medicare Modernization Act prohibited Medicare from being able to use its purchasing power to lower the cost of drugs. Gee, we wonder which industry got that put into the bill? The Inflation Reduction Act changes this by allowing Medicare to begin negotiating the cost of ten drugs in 2026 and then another ten a few years later. Obviously, they will tackle those drugs that are the most expensive first. All these cost savings may come at a cost – like increasing premiums for Part D.
MORE ABOUT THE INFLATION REDUCTION ACT
- Congress’ Joint Committee on Taxation estimates that fewer than 150 companies will be subject to the new minimum tax rate, about half of which are in manufacturing. The new law still allows for exemptions related to equipment purchases that could help blunt the impact to manufacturing companies. The higher minimum tax rate is expected to raise about $200 billion in new corporate tax revenue over the next ten years, equating to an increase of less than 5% over that time frame.
- The 1% tax on share repurchases (buybacks) is expected to raise an even more modest $74 billion over the next decade and will go into effect at the end of this year. That start date allows companies time to accelerate repurchases before the new tax goes live – so expect to see additional share repurchase activity before the end of the year.
- Once the new tax goes into effect, it could slow companies’ propensity to buy back their own stock. In turn, those firms could buy back less stock, allow the extra cash to sit on their balance sheet, make acquisitions, or increase dividends. Whichever path companies choose, it could leave less money for stock owners, though this would only be a marginal change. For context, over the last few years, companies in the S&P 500 have spent about $800 billion per year in stock buybacks.
Will the bill actually bring down inflation?
- The rapidly rising price levels that the US economy currently faces are driven by factors largely outside of the government’s control: the aftereffects of COVID shutdowns and the war in Ukraine. As such, the government has limited options.
- Both the government’s own Congressional Budget Office and the University of Pennsylvania’s Penn Wharton Budget Model suggest that the bill will have a negligible impact on inflation. Though both analyses agree that by year five, the new provisions would contribute to reducing the deficit.
Inflation Reduction Act of 2022, Effect on the Budget
Net deficit reduction (+) or increase (-) from spending and revenues
Sources: Penn Wharton Budget Model, Congressional Budget Office
Is inflation slowing?
- Earlier this month we had the first official report showing that inflation levels may have peaked. The consumer price index increased by 8.5% from a year ago and was flat compared to the prior month.
- This difference between year-over-year change and month-over-month was the source of yet another political debate between the Left and Right. So, who was correct? Well, both. While year-over-year increases in prices hurt consumer pocketbooks, the leveling off from the previous month provides a clue that overall price increases may be slowing. It is this latter point that sent stocks soaring.
Consumer Price Index
Level of consumer prices and rate of change over different periods
Sources: U.S. Bureau of Labor Statistics, Kestra Investment Management
Inflation is an enormously difficult beast to tame. The good news is that inflation does indeed appear to be slinking back into its cage thanks to the easing of global supply chain disruptions and the Federal Reserve’s tightening of monetary policy. And the stock market has been applauding.
The real legacy of the new legislation will be in providing additional funding for health care and clean energy. Individuals will have their own opinions on those topics. What we can say is that the Inflation Reduction Act is unlikely to lower inflation at least not in the near term, just as it is also not likely to hamper corporate profitability in a significant way.
LOOKING AHEAD
As we head into the last part of the year, we thought it a good time to look ahead to 2023. Let’s talk about the two elephants in the room: recession and inflation. In some measure, both are in the hands of the Federal Reserve. The Fed began raising interest rates earlier this year in hopes of bringing inflation under control. However, it takes time for the medicine to work, and it is usually a lag of 9-12 months before the medicine kicks in. We hope to start seeing an easing of inflation in the 4th quarter and into 2023.
Unfortunately, we expect to see inflation above the 2% target rate that the Fed likes in 2023 – maybe 4% plus or minus 1%. If the Fed gives the economy too much medicine in the form of higher interest rates, then the odds of a recession increase dramatically. Even then, a recession would likely be short-lived and shallow. With or without a recession, 2023 will not likely be a banner year for the economy. While the recent rally over the past two and half months has calmed many investors, patience is going to be needed as we work through this difficult time.
HIGH EARNERS ARE FLYING AWAY
Financial technology firm SmartAsset recently did an analysis of taxpayers from each state that were making $200,000 or more (6.8% of the population falls into this category) to determine migration patterns between 2019 and 2020. These migration patterns will positively or negatively impact a state’s tax revenues and fiscal situation. The more the inflow the better, and, of course, the reverse is also true. Some of these might surprise you. Here are the top ten with a gross/net inflow of taxpayers making $200,000 and above:
Gross / Net
10) Connecticut 5,375 / 123
9) Tennessee 6,075 / 2,743
8) South Carolina 6,545 / 3,967
7) Georgia 6,796 / 570
6) Colorado 8,294 / 2,624
5) Washington 8,702 / 903
4) Arizona 9,418 / 5,268
3) North Carolina 10,322 / 4,713
2) Texas 18,417 / 5,356
1) Florida 32,019 / 20,263
Did you notice that four of these states, including Florida, do not have a state income tax? The survey also noted that eight of these states fall within the Sun Belt.
THE GENDER PAY GAP STARTS EARLY
An often-cited statistic from the Department of Labor reports that women across the workplace earn an average of 82.3 cents for each dollar earned by men. How long do you think it takes for the disparity to show up in salaries? Any guesses – one year, five years, or even more?
The Wall Street Journal reported that within three years, significant salary differences appear between men and women graduating from the same academic institutions with the same major. The article mentioned the following examples:
- “Men who graduated with a dental degree from the University of Texas Health Science Center at San Antonio earned a median $140,000 three years out, compared with $103,000 for women.”
- “At Georgetown University, men who received undergraduate accounting degrees earned a median $155,000 three years after graduation, a 55% premium over their female classmates.”
Though the article goes on to point out that there are many potential reasons for the pay gaps including the motherhood penalty, women choosing lower-paying career paths and men negotiating salaries more aggressively than women, it does significantly impact a woman’s ability to build her wealth over her lifetime.
IRS INTEREST RATES GOING UP
On August 15th, the Internal Revenue Service announced that the interest to be paid on under and over tax payments will go up beginning October 1th. The current rate increased on July 1st to 5% annually and is now going up to 6%. This rate is compounded daily. Here are the amounts for each type of taxpayer:
- 6% for overpayments (5% for corporations)
- 3.5% for the portion of a corporate overpayment exceeding $10,000
- 6% for underpayments (taxes owed but not fully paid)
- 8% for large corporate underpayments
NOBODY WON
Unfortunately, no one correctly guessed the three stocks in the S&P 500 that actually have two share classes. They are Alphabet Inc. (Google), Fox Corporation and News Corp. Berkshire Hathaway has two share classes, but only one (the class B shares) is included in the S&P 500.
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