Clay Northam Blog

  • Why the Fed Is Raising Interest Rates and What It Means

    August 10, 2017

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    Why the Fed Is Raising Interest Rates and What It Means | Clay Northam Wealth Management

    Unless you’ve spent the last eight years on Mars or asleep, you know that the biggest complaint is that the U.S. economy is sluggish:

    • At an average growth rate of around 2% a year, the country’s recovery following the Great Recession of 2007-2009 has been the weakest since World War II.
    • The economy hasn’t grown at an annual rate of 3% in the last 12 years.
    • The latest GDP report showed that in the first quarter of this year, the economy grew at an annualized rate of just 1.4%, and the New York Federal Reserve Bank estimates second-quarter growth at 1.9%.

    So why, then, you might ask, did the Federal Reserve Board – the country’s central bank – raise interest rates by 0.25% to 1.25% on June 14? It was the second such hike this year, and the third since the Fall of 2015. Before we answer the question, let’s take a few steps back to understand why and how the Fed changes interest rates.

    By law, the Federal Reserve Board has two objectives: to maintain a stable currency by keeping inflation low, and to seek full employment. Its primary tool for accomplishing that is the target interest rate it sets for overnight loans between banks that are members of the Federal Reserve system.

    The Fed defines an amount of reserve deposits every bank has to meet at the end of every day, and when a bank runs short, it’s forced to borrow money from banks that have excess reserves on hand. The rate for these loans is called the “Federal Funds Rate,” and the lending banks have incentives to charge the Fed’s target rate on these overnight loans. While the rate actually fluctuates daily around the Fed’s target, it represents a basic cost for banks. Its effect ripples through the entire financial system in terms of the rates banks charge borrowers, both businesses and consumers alike.

    By making loans more expensive, the Fed slows spending, as borrowers have less cash to pay for goods and services. The resulting reduction in demand puts the brakes on the economy and inflation. The opposite is also true. When the Fed lowers rates, borrowers have more cash to spend, and if they do in fact spend it, the economy grows more quickly.

    One of the by-products of rapid economic growth is inflation. When inflation gets out of control – as it did in the 1970s – the Fed raises interest rates to suppress demand. If rates get too high, they not only can cause inflation and growth to slow down but bring on a recession. The graph below shows the history of the Fed’s effective changes to the Fed Funds Rate interest rate; the grey bands highlight recessions, periods when the economy contracted. Generally, as you can see, the Fed raised the Fed Funds Rate leading up to a recession.

    Effective Federal Funds Rate

    There have been few times when the U.S. inflation rate has hit double digits. Two of those times were in 1973-75, when it reached 11.8%, and in 1981 and 1982, then it was at 13.9% and 11.8%, respectively. As you can see in the graph, the Fed responded by raising the Federal Funds rate.

    In the early 1970s, the U.S. economy was hot: it grew by more than 5% a year in 1971 and 1972, unemployment fell from 6.0% in 1971 to 4.9% by 1974, and inflation zoomed from 3.3% to 12.3% over the same period. The Fed responded raising its target Federal Funds rate six times, from a low of 3.5% in January 1971 to a high of 13.0% by July 1974, by as much as 4 percentage points at a time. The Fed’s actions precipitated a 16-month recession that resulted in a 3.2% loss in Gross Domestic Product (GDP) and unemployment reaching a high of 9%. Inflation bottomed out at 4.9% in 1976.

    Recovery from the 1973-75 recession was fast and furious. In 1978, the economy grew 5.6%, but in that same year prices rose 13.3%. Again, the Fed intervened, raising its Fed Funds target rate as high as 20.0% four times, in March and December 1980, and in January and May of 1981. This time there was a “double dip recession.” The first dip lasting just six months in 1980, and the second running from July 1981 to November 1982. In the first recession, unemployment peaked at 7.8% and the economy contracted by 2.2%. In the second, unemployment reached a high of 10.8%, and the economy gave up 2.7% of activity. There was pain and suffering throughout, but by 1984 inflation had been “tamed” at just 3.9%.

    Today’s U.S. economy looks almost nothing like the two episodes we’ve just studied. We’re eight years out of the Great Recession, and the economy is huffing and puffing along. As of June, GDP was growing at an estimated annual rate of around 2% and inflation was about the same. To rescue and revive the economy, the Fed lowered its Fed Funds target to an all-time low of 0.25% in December 2008. That rate prevailed until late 2015 when, as we’ve noted, the Fed raised it by 0.25% to 0.50%, followed by two more equal hikes this year. But with growth and inflation feeble, we return to our opening question: why?

    The answer lies in the Fed’s second objective: to maintain full employment, which economists define as between 4.0% and 5.0%. That’s the level at which business competition for labor intensifies and wages typically begin to rise, threatening higher inflation. The rate as of June was 4.4%, right in the Fed’s sweet spot. So was inflation: the Fed’s target rate for that is 2%, and that is where the inflation rate now stands. While there hasn’t been any marked increase in inflation yet, it’s generally acknowledged that it takes 18 months for Fed actions to have their intended effect, so the Fed has been acting against inflationary pressures that it believes will appear late next year.

    So, both of the Fed’s goals for the economy have already been achieved. In the view of the Fed’s governors, therefore, it’s time to remove the monetary stimulus of low interest rates. In fact, Fed watchers believe the central bank will continue to raise its Fed target rate by the same, modest 0.25% bump, as many as two more times by the end of 2018.

    Underlying that view is that the economy is continuing to expand, supported by the fact that the stock market has continued to advance to all-time highs. What’s more, a study published in 2015 by Stanford University economist Charles I. Jones found that the U.S. economy’s long-term growth rate, going back as far as 1870, is 2.0% – approximately where it is expected to be for this year -– and that the higher rates of growth it achieved after World War II were an aberration, not the norm.

    As Forbes magazine contributor Len Sherman asked in a headline on June 2, “Can the U.S. Ever Get Back to 3% Growth?” Perhaps. That is, after all, one full point below President Trump’s stated goal. But if we get there, you can expect the Fed to have raised the Fed Funds Rate several, if not many times more.


  • Trump Wants to Cut Taxes by $6+ Trillion: Who Gets What?

    March 30, 2017

    By:

    Trump Wants to Cut Taxes by 6 Trillion Who Gets What? | Clay Northam Wealth Management

    President Donald Trump has proposed the largest tax cut since Ronald Reagan’s 1981 plan, totaling some $6 .2 trillion (yes, that’s right – “trillion” with a “t”) over ten years, with most of it going to the wealthy and to businesses. If that means you, you have reason to smile – at least for now.

    At the moment, Trump’s plan is only a proposal, and it has already been revised twice since he unveiled it as a candidate for the presidency in 2015. That revision lopped off about $3 trillion in cuts, and the current proposal has yet to be written up in a bill to present to Congress. Still, it’s twice as large as House Republicans are calling for.

    Given that Trump wants to increase spending on both the military and infrastructure while holding Medicare and Social Security benefits steady, economists say that without huge cuts in other kinds of spending his tax plan would dramatically increase both the federal budget deficit and government debt, effects that are anathema to every Republican in Congress.

    In this light, it’s premature to expect every feature of the Trump tax plan to be signed into law. But, after the repeal and replacement of the Affordable Care Act, a huge tax cut combined with tax simplification, is the primary domestic legislative objective of both the Trump administration and congressional Republicans. It’s reasonable to expect that when passed, the new tax code will resemble many of the features, if not their precise values, that Trump has put forward.

    So, without further ado, here’s a summary of the Trump tax plan and how it would affect taxpayers. First, we’ll look at changes in personal taxes, and then the changes proposed for business taxes.

    Personal Taxes

    There are eight key changes to personal taxes in the Trump proposal:

    • Lowering tax rates and collapsing the current seven brackets into three, as shown here:

    2016 Brackets

    Marginal Tax Rate Single Filer Income Joint Filer Income
    10% $0 – $9,275 $0 – $18,550
    15% $9,276 – $37,650 $18,551 – $75,300
    25% $37,651 – $91,150 $75,301 – $151,900
    28% $91,151 – $190,150 $151,901 – $231,450
    33% $181,151 – $413,350 $231,451 – $413,350
    35% $413,351 – $425,050 $413,351 – $466,900
    39.6% $425,051+ $466,901+

    Trump Brackets (latest)
     
    Marginal Tax Rate Single Filer Income Joint Filer Income
    12% $0 – $37,499 $0 – $74,999
    25% $37,500 – $112,499 $75,000 – $224,999
    33% $112,500+ $225,000+

    • Raising the standard deduction from $6,000 per person to $15,000 for single filers and $30,000 for joint filers, while repealing personal exemptions.

    • Allowing deductions for care for children under the age of 13, and the creation of tax-advantaged Dependent Care Savings Accounts.

    • Eliminating the Head of Household filing status (for unmarried filers with children under the age of 19 and/or disabled dependents).

    • Capping itemized deductions to $100,000 for single filers and $200,000 for joint filers.

    • Elimination of the Affordable Care Act’s 3.8% investment income tax (assessed in 2016 against those in the two highest income tax brackets).

    • Eliminating estate and gift taxes, while assessing capital gains taxes on the owner’s death, subject to a $5 million exemption for individuals and $10 million for married couples.

    • Eliminating the Alternative Minimum Tax.

    What’s the potential impact of these changes? According to an analysis by the Tax Policy Institute, “the plan would cut taxes at every income level, but high-income taxpayers would receive the biggest cuts, both in dollar terms and as a percentage of income.” The Institute went on to note that the plan would:

    • Cut the average household 2017 tax bill by $2,940 and increase after-tax income by 4.1%, but

    • Reduce the bill for the highest-income taxpayers (those with incomes of more than $3.7 million) by almost $1.1. million, or more than 14% of after-tax income.

    • For households in the middle fifth of income, cut taxes by an average of $1.010, or 1.8% of after-tax income.

    • Provide an average reduction of $110 or 0.8% of after-tax income for the poorest fifth of all households.

    • Marginally increase the tax bill for people who previously filed as a head of household and for large families.

    The tables below shows the proposed migration of household income from the 2016 tax brackets to the brackets in Trump’s latest proposal:


    Single Filers Adjusted Gross Income
     
    Over Up To Current Marginal Rate Trump Marginal Rate
    $0 $10,350 0% 0%
    $10,350 $15,000 10% 0%
    $15,000 $19,625 10% 12%
    $19,625 $48,000 15% 12%
    $48,000 $52,500 25% 12%
    $52,500 $101,500 25% 25%
    $101,500 $127,500 28% 25%
    $127,500 $200,500 28% 33%
    $200,500 $423,700 33% 33%
    $423,700 $425,400 35% 33%
    $425,400 Unlimited 39.6% 33%

    Joint Filers – No Dependents Adjusted Gross Income
     
    Over Up To Current Marginal Rate Trump Marginal Rate
    $0 $20,700 0% 0%
    $20,700 $30,000 10% 0%
    $30,000 $39,250 15% 12%
    $39,250 $96,000 25% 12%
    $96,000 $105,000 25% 25%
    $105,000 $172,600 28% 25%
    $172,600 $252,150 33% 25%
    $252,150 $255,000 33% 25%
    $255,000 $433,750 33% 33%
    $433,750 $487,650 35% 33%
    $487,650 Unlimited 39.6% 33%

    Source: Tax Policy Institute, Oct. 11, 2016


    The following table shows how tax bills would change under the current Trump proposal by household income percentile:
     
    Quintile/Percentage Change in After-Tax Income Share of Federal Tax Change Average Federal Tax Rate Change Average Federal Tax Rate Percent Change Average Federal Tax Rate Under Proposal
    Lowest Percentile +.08% 1.1% -$110 -0.8% 2.9%
    Second Quintile +1.2% 3.0% -$400 -1.1% 7.3%
    Middle Quintile +1.8% 6.6% $-1,010 -1.5% 12.1%
    Fourth Quintile +2.2% 11.3% -$2,030 -1.8% 15.5%
    Top Quintile +6.6% 77.7% -$16,660 -4.9% 21.2%
    ALL +4.1% 100% -$2,940 -3.3% 16.8%
    UPPER PERCENTILES
    80-90% +2.3% 7.9% -$3,270 -1.9% 18.3%
    90-90% +2.8% 6.2% -$5,350 -2.1% 20.0%
    95-99% +6.0% 16.3% -$18,490 -4.5% 21.0%
    Top 1 Percent +13.5% 47.3% -$214,690 -9.0% 24.4%
    Top 0.1 Percent +14.2% 24.2% -$1,066,460 -9.3% 25.1%

    Source: Tax Policy Institute, Oct. 11, 2016

    Business Taxes

    The leading feature of the Trump tax plan for business is a reduction in the nominal top income tax rate by more than half. But the Trump administration has said that its proposed changes in business taxation would be “revenue neutral ,” in part because of the elimination of various “special interest” tax breaks and increased revenues from the repatriation of foreign profits. While that may be true, depending on the industry and size of company, some businesses would pay more in taxes while others would pay more.

    Here is a summary of Trump’s proposed changes for business:

    • Reducing the top corporate income tax rate from 35% – nominally, among the world’s highest when state and local taxes are taken into account – to 15%.

    • Owners of “pass-through” enterprises — sole proprietorships, partnerships and S corporations – would be subject to a 15% tax on pass-through income instead of their corresponding personal income tax rate.

    • The ability to deduct the full amount of capital investments (equipment, plant and inventories) in the year they are made instead of depreciating them over a number of years. If taken, however, businesses will not then be able to deduct interest expenses.

    • For multinational businesses, a one-time 10% tax on repatriated cash holdings, payable over 10 years – a measure Trump expects to result in $2 trillion flowing back to the United States; and no income tax on future foreign profits.

    • A border adjustment tax on imported goods and an exemption on exports. The President and his advisers anticipate that the tax would raise $1 trillion over 10 years. Critics of the measure argue that businesses would pass on the tax on imports to U.S. consumers by raising prices, while supporters argue that those higher prices would be offset by a stronger U.S. dollar.

    It’s unclear when the Trump administration will submit a bill to the House of Representatives, where tax legislation originates, when it is likely to become law and how much the law will resemble the President’s current proposal. The current House proposal undercuts Trump’s tax cuts by about half, so there is a wide gap to be resolved. It’s probable, however, that as long as Republicans control both the White House and Congress, federal taxes will be lowered and the tax code simplified.


  • What Your Credit Score Means and How You Can Improve It

    November 16, 2016

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    What Your Credit Score Means and How You Can Improve It | Clay Northam Wealth Management

    Your credit score is one of the most important parts of your financial identity. A bad score can prevent you from buying the home of your dreams, saddle you with tens of thousands of dollars in additional interest expense over your lifetime, keep you from being hired for the job you want, or prevent you from being approved for a life insurance policy. On the other hand, a good score can open many doors and with smart debt management, help you live a happier life.

    (more…)
  • Tax-Advantaged Investing for College

    August 24, 2016

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    Tax-Advantaged Investing for College | Clay Northam Wealth Management

    With the price of a college education continuing to increase faster than the rate of inflation, it’s necessary to do more than just save for it. Unless your child is going to qualify for a full scholarship, you’re best advised to invest for it. This means placing the money you put aside for college so that it gets all the help it can to grow faster than college costs rise.

    (more…)
  • After the Brexit Vote: “Keep Calm and Carry On”

    July 20, 2016

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    After the Brexit Vote: “Keep Calm and Carry On” | Clay Northam Wealth Management

    It was the summer of 1939 – believing that war and the bombing of British cities were unavoidable – the British government was concerned with maintaining civilian morale. So it spun out a typically British, stiff-upper-lip phrase designed to boost confidence and printed it on more than two million posters – which, oddly, it never actually distributed. Today, though, you can find the phrase and various permutations of it appearing on posters, tee shirts, tea mugs and all sorts of decorative wear: “Keep Calm and Carry On.” (more…)