inflation rate

What Is the Fiscal Cliff?

Erin C. O'Neil — Fri, 06 Jul 2012 10:24:08 +0000

If you’ve been surfing the web lately, you’ve probably seen the phrase “fiscal cliff” thrown around on finance, business, and political sites.

The fiscal cliff refers to a series of fiscal policy changes set to take place at the end of 2012. While each are worrisome alone, the combination of fiscal and political changes has many concerned that the effects could snowball, resulting in a severe slowdown of the economic recovery. The November Presidential Election, which further complicates matters. Given the seeming inability of both parties to work together, it seems unlikely that either Democrats or Republicans would be willing to strike a deal on fiscal issues before the 2012 election plays out.

Still, there’s no reason to consider jumping off that fiscal cliff just yet. It’s likely that politicians will strike some sort of compromise at the eleventh hour, and that the Fed may rework the Operation Twist program given the economy’s uncertainty. But the combination of increased taxes and budget cuts could prove dire for the U.S. economy. While spending cuts would lead to a lower deficit, they could also cause the GDP to contract up to an estimated 1.3% in the first quarter of 2013, according to the Congressional Budget Office. (See also: Tax Brackets Explained)

Here’s an overview (albeit a very condensed version) of what comprises the fiscal cliff.

The Monetary Cliff

The “monetary cliff” typically refers to the end of the Federal Reserve’s “Operation Twist” program, set to complete at the end of 2012. It’s far more complicated than this, but the program essentially consists of the Federal Reserve buying treasuries from 6 to 30 years in duration to keep interest rates low. The concern is that if Operation Twist does in fact end in December of 2012, interest rates could rise, further crippling the economy.

The "Sequester" Backlash

Remember how last year the Federal budget super committee was unable to reach a deal on spending? Well, many of those postponed budget decisions could go into effect at the beginning of 2013.

The automatic spending cuts set to kick in on January 2, 2013, would cut 1.2 trillion dollars total in spending. The majority of the cuts are split between defense and domestic spending. In addition, the Federal government will reach the “debt ceiling” at the end of 2012.

Expiring Tax Breaks and More

Several tax breaks and other benefits are set to expire.

The Bush Tax Cuts

The expiration of the Bush Tax Cuts could potentially affect taxpayers across the board. This issue is sure to result in some form of gridlock; Republicans are in favor of extending all the tax cuts, while Democrats only want to extend the cuts for those making under $250,000 a year.

Emergency Unemployment Benefits End

This one is pretty self-explanatory. An end for benefits could result in the loss of unemployment income for millions of Americans, many of whom rely on it for bills and living expenses.

Payroll Holiday Tax Ends

The expiration could result in up to a 2% tax increase for workers.

Measures to Protect the Middle Class From AMT (Alternative Minimum Tax)

When these expire, middle class families will see a hike in their federal taxes.

Things get a lot more complex, but that's the general idea behind the fiscal cliff. Is this another example of fear mongering by the media, or a legitimate economic crisis waiting to happen?

This article is from Erin C. O'Neil of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

While Waiting for Rates: I-Bonds

Philip Brewer — Mon, 28 Feb 2011 13:00:09 +0000

Your short-term cash in a savings account or money fund isn't earning much yield. You could earn a bit more by locking your money up for a longer term, but that could be costly if your money is still locked-in when rates eventually do rise—and especially costly if inflation goes up.

If only there were some instrument that paid a reasonable return, provided some inflation protection, and still gave you access to your money if rates went up.

As you'll have guessed from the title, there is: the series-I savings bond.

The I-Bond provides excellent inflation protection, by paying a rate that consists of a portion that's fixed for the life of the bond, plus a portion that changes every six months based on recent inflation. A bond you buy right now will only pay the inflation rate, because the fixed portion is zero. However, there'll be a new fixed rate announced May 1st.

The I-Bond does this while providing considerable flexibility for you to decide how long you want to leave your money in. If it's providing a good return, you can choose to leave your money in for 30 years. Alternatively, you can take your money out any time after one year has passed. If it's been less than 5 years, you forfeit the last three months interest payments—but since rates are so low, that's not much of a penalty.

Four Scenarios

There are four scenarios that you need to consider: interest rates might stay low or they might go up; at the same time the inflation rate might stay low or it might go up. Let's look at each of those in turn, and see how the I-Bond works in that scenario.

Rates stay low, inflation stays low

This is basically the situation we've been in since the financial crisis began. The I-Bond is an adequate investment, keeping you even with inflation.

Your best move: Hold your bonds. With low rates, you probably can't do better elsewhere anyway.

Rates go up, inflation stays low

This seems like the least likely scenario, but if this is what happens, you'd be okay.

Your best move: Cash in your bonds and then invest in something paying the new higher rates. You'll have to give up three month's interest—but since inflation is low, that wouldn't be much.

Rates stay low, inflation goes up

This is generally the worst situation for the saver, but the I-Bond does a reasonably good job of protecting you, and you can't do much better elsewhere anyway. (People who locked in their money at low rates without inflation protection, on the other hand, are screwed.)

Your best move: Hold your bonds and keep up with inflation.

Both interest rates and inflation go up

In this scenario you're protected from the inflation, but you're not earning the new higher rates.

Your best move: Cash in your bonds. You'll pay a penalty, but it will be small (as long as you do it early, before you'd earned much of the new, higher inflation adjustment). Then reinvest at the higher rates.

Take Your Time

Probably the best move overall is to adopt this strategy gradually. For one thing, since you can't get your money out for the first year, you don't want to put in any money that you might need during that time. In any case, you're only allowed to buy $5000 worth of savings bonds per year anyway.

If you make a modest investment into I-Bonds each year, all but the most recent batch will be available to cash in anytime that's the right move. And, once five years have passed, some of them will be available to cash in with no penalty.

In fact, once you reach that point, you can start thinking of your savings bonds as part of your emergency fund. They can be cashed in at any bank, so they're almost like cash. (But they're more secure than cash, because if they're lost, stolen, or destroyed, you can get them replaced.)

If you want to invest larger amounts, consider TIPS. They're currently paying higher rates. (However, they don't have the feature of allowing you to cash them in early.) I wrote an article comparing TIPS and I-Bonds a while ago.

See the Treasury's site on I-Bonds for all the details on current rates, how the rate is calculated, how to buy them, etc.

It's entirely possible that interest rates will stay low. In fact, the Fed is pretty much promising to keep rates low for "an extended period." That's assumed to mean at least six months, but it could be much longer than that. I-Bonds are a reasonable choice while you're waiting—and after May 1st, depending on what the Treasury sets as the new fixed rate, they might get better.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

All About Deflation

Philip Brewer — Thu, 05 Aug 2010 13:00:05 +0000

Deflation is back in the news, and for good reason: It's a real risk.

Let me say up front that my own experience makes me much more inclined to worry about inflation. I have first-hand experience with the harm of inflation: the 14 percent inflation of 1980-1981 devastated my very first budget. Deflation, on the other hand, has always been a purely theoretical problem, and one that doesn't even sound all that bad. Falling prices? What's not to like?

So, here's the first thing: Deflation isn't falling prices. Just as inflation is the money becoming less valuable, deflation is the money becoming more valuable.

Prices tend to fall during a period of deflation, but prices change for lots of reasons, and other factors can easily cause some prices to rise, even during deflation. For example, widespread drought could easily cause food prices to rise during deflation.

Cause of deflation

Just as inflation is caused by an increase in the money supply, deflation is caused by a decrease in the money supply — but it's not quite that simple.

The "money supply" isn't one single thing. Anything that you can spend is money, so that's not just cash and checking accounts and money fund balances. For example, the available credit in your Home Equity Line of Credit (if the collapse in housing prices has left you with any) is pretty close to being money, as is the available credit on your credit cards. Even the value of your brokerage account is practically money — you could sell your stocks and have the cash in four or five days.

The supply of those sorts of money collapsed during the panic at the beginning of the crisis, as credit lines were cut and asset values crashed. The effective supply of money fell even further, because people quit spending — and money that people won't spend has little effect on prices.

The Federal Reserve stood against this collapse in the money supply by creating bank reserves and by buying assets (putting cash in the hands of whoever was selling — mainly the Treasury and the government agencies that support the mortgage market). Most people (including me) saw that surge in bank reserves and money and assumed that inflation was right around the corner. It's now pretty clear that the Fed was right and I was wrong. All that money just barely managed to stave off deflation.

How deflation hurts

Falling prices doesn't sound so awful, but remember that falling prices are just a symptom. When the money unexpectedly becomes more valuable, the result is pain for anybody who has to come up with cash now to satisfy a deal where the price was set earlier — your rent, your cell phone contract, your health insurance all cost more than you thought they were going to when you signed the contract.

To make matters worse (and more complicated), some prices are less prone to changing than others. In particular, wages are generally sticky on the downside. That means that rather than a smooth adjustment with wage cuts, deflation tends to produce high unemployment.

The real place that deflation bites, though, is debt. Just as inflation makes winners out of people who borrowed money at low, fixed rates, deflation makes them losers, crushing their households under the burden of paying off old debts with money whose value rises further and further above what they borrowed. In a society where many people have debts, the pain is spread far and wide.

Dealing with deflation

Of course deflation has winners as well as losers, at least on the surface. Anyone with cash tends to benefit as their money becomes more valuable. Anyone with long-term bonds at fixed rates can do spectacularly well. Anyone with a secure job and little or no debt has a good shot at doing just fine.

In the real world, things aren't quite so happy. Those long-term bonds are especially likely to default; even the most secure jobs can be lost during a time of deflation. Even cash hasn't been a perfect safe haven historically, although our bank deposit insurance has held up OK so far.

The one good thing about deflation as a risk is that the steps to protect yourself are the same practical steps that we often talk about here on Wise Bread: reduce fixed expenses, avoid debt, boost your emergency fund. It makes more sense than ever to delay purchases, and since your money is getting more valuable, holding cash is a winning proposition.

The risk

As deflation starts to bite, more and more households start to follow this advice: They avoid debt, they reduce spending, they hoard cash. Because of that, besides hurting everyone with debts and making it tougher to find and keep jobs, deflation hurts the whole economy. This effect can snowball, producing a recession that's just about impossible to escape from — see the experience of the US in the 1930s.

Because of that, in 2009 there was a consensus within the Federal Reserve to do whatever it took to prevent deflation. (They proceeded to buy $300 billion of Treasury securities and $1.55 trillion of government agency securities.)

And that's what makes the current situation so risky: That consensus seems to have broken down. It's by no means clear that the Fed would repeat purchases on that scale. The upshot is that deflation, and all the pain it brings, is once again a real risk.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Don't let low interest rates make you stupid

Philip Brewer — Thu, 11 Jun 2009 14:39:51 +0000

When I went off to college in 1977, inflation was high and rising, but the maximum interest rate you could earn on a savings account was capped by the government at a fraction over 5%. The conventional wisdom was "It's dumb to hold cash when inflation is over the rate you can earn." I absorbed that conventional wisdom, and it led me to make some dumb decisions.

I had, through gifts and part-time jobs, managed to save over the course of my entire life up to then, about $1000. If I'd had any sense, I'd have understood that this sum was capital. I didn't, though--and because of that, I suffered from a lack of capital all through college.

Because I didn't understand, here's how things worked out: The part-time jobs I had on campus earned me about $100 a month, which was pretty good money in those days. (In fact, it was all pretty good, except that the money wasn't paid until the 10th of the month after I'd earned it.) My expenses were pretty much zero (I lived in a dorm room and had a meal plan), so my earnings were pretty much entirely disposable, so $100 a month added up to plenty to keep me in pizza and sodas, with enough left over for all the pens and notebooks I could use. In fact, I generally ran a surplus over the course of the semester.

The problem I faced though--over and over again-- was that the semester was front-loaded with expenses. The big one was books (about $100 to $150, payable as soon as the semester started), but also incidentals for the dorm room (tea, snacks, etc.).

So, I showed up the first week of September, shelled out $150, and immediately found myself broke. And I stayed broke all month and well into the next month. Finally, on October 10th, I'd get $100 (not quite enough to get back to even). Worse yet, I typically had to send the money back to my bank, adding a couple days for the mail to get through--plus, banks in those days usually insisted on 5 to 10 days for an out-of-state check to clear. So I often didn't have access to the money until October 20th.

I didn't have any way to go into debt, so I wasn't really behind all the time, but it sure felt like that--each paycheck would merely get me back even again, so the upshot was that I was behind all the time. Finally, after the semester was over, on the 10th of the first month of vacation I'd get one last paycheck for the last month of the semester--and, with my accumulated surplus, be back even again.

If I'd only understood the nature of capital! I could have stashed my $1000 in my savings account, except for, let's say $250 transfered to my checking account. Then I'd have been able to pay my $150 beginning-of-semester expenses and still had $100 to see me through until the paycheck showed up. Instead of being behind all the time I'd have been ahead all the time. When that last paycheck had turned up on the 10th of the first month of vacation, I'd have been just about able to top off my checking account for the following semester. (And if I had a job during vacation, maybe even get a little bit ahead.)

The problem (aside from just not understanding capital) was that "conventional wisdom" I mentioned at the beginning. Here's a graph of the inflation rate from 1977 to 1981. As you see, it started the period higher than what a small saver could earn, and would soon soar to almost three times that.

Over that time I read a lot of books about money management. The books suggested several strategies for dealing with the problem. If you had lots of money (over $10,000) you could earn market rates on treasury securities or 6-month bank CDs. Money market funds were just becoming available (with minimums of $1000 or more). You could also buy gold (private ownership was legalized for Americans in 1974) or silver. Or you could just buy stuff that you were going to use (the other bit of conventional wisdom being "buy now before the price goes up.")

Most of those strategies required more cash than I had, but it just seemed dumb to leave my $1000 sitting in my savings account, losing purchasing power every day. Rather than do something as dumb as that, I went ahead and spent most of it over the course of my first year of college--hence my subsequent shortage of capital.

In fact, though, none of that was necessary. Sure--if I'd stashed $1000 in a savings account earning 5.25% it would have grown to only $1227 by the time I'd graduated, rather than the $1500 it would have taken to have preserved my purchasing power. However, that downside would have been much more than offset by the advantage that I'd have spent 4 years being comfortably well off all the time, rather than being broke all the time. Plus, I'd have come out of the whole thing with $1227!

This seems topical now, because even though inflation rates are low, interest rates are also very low. It's easy to imagine that, when cash earns almost nothing, it's dumb to hold it. It's easy to start thinking that you should invest it in something with a better return--or even just spend it. My counter to that is that holding a little capital returns a bunch of other advantages totally aside from the cash return--starting with the win of not being broke.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: