Monetary Bazooka Fired

The Federal Reserve Open Market Committee (FOMC) today announced a new program of quantitative easing that goes above and beyond all previous actions they’ve taken to stimulate the economy. For the past several years, the Fed has been buying primarily long-term treasuries with essentially newly printed money, in an attempt to inject liquidity into the economy and keep long-term treasury rates (the rates that long-term loans like mortgages rely on) low. The new program announced today, which goes into effect starting tomorrow, has the Fed buying mortgage-backed securities in the amount of ~$40 billion per month with no fixed end date. The purchase of these securities should directly lower mortgage rates (all else being equal) and allow for another wave of refinances for those who qualify. The purchases themselves were mostly expected by the market given lackluster economic growth and an anemic job market. But, the open-ended nature of the purchase program is the bazooka of monetary weapons.

Ben Bernanke, chairman of the Fed, indicated that the Fed will continue the monthly purchases until economic conditions improve. Read another way, that means the Federal Reserve will continue print money until there is enough money to go around. That money will flow into the economy through lower mortgage and other loan payments for borrowers and through the reduced incentive to hold cash savings since interest rates are virtually zero. If $40 billion per month isn’t enough, they’ll do more. If mortgage-purchases aren’t enough, they’ll print money to purchase other assets too. It’s a commitment that essentially puts a floor under the economy and under asset prices, thereby removing the risk of deflation. Without the risk of deflation (think of housing prices falling), the desire to purchase assets can return (think of people in their early 20’s deciding to buy condos again instead of renting). While the ramifications of the commitment will take a while to filter through the economy, they should result in the following:

· Lower mortgage rates for those with good credit attempting to obtain conforming loans (loans for principal residence that are under the FHA loan limits for the county of residence – typically $417k)

· Another wave of refinancing reducing payments for existing borrowers and freeing up more for discretionary spending

· Reduced risk in house price declines leading to more buyer confidence leading to a bottom to the housing market

· Higher business confidence that the economy will not “double dip” back into recession (the Fed simply won’t let it happen)

· A very gradual improvement in the job market

· A continuing erosion in the value of cash (no interest paid and the cost of living will start to increase more rapidly, especially in volatile food and energy prices)

· Higher inflation (virtually a guaranteed byproduct in eliminating the risk of deflation), higher energy prices, higher food prices.

It’s that higher inflation that will be the next big economic problem in my opinion. How fast it happens is unknown, but when it does, the Fed will have to reverse course and start extracting stimulus or face a 1980s-like bout of hyperinflation. Their forecasts are for that to occur beyond 2015 (they currently promise to keep rates low through 2015 and wouldn’t do that if they didn’t think inflation would be in control through at least that year). I’m not so sure, since I think a promise for an unlimited amount of stimulus could very quickly cause inflation expectations to become unanchored. Either way, taking deflation, double-dip recession, and maybe even depression off the table is certain to be a short-term net positive on the economy in aggregate. It’s also virtually certain to make cash have less and less value over time. So, what should you do to take advantage of today’s changes:

1) Only hold enough cash to serve as an emergency fund and to pay for short-term upcoming lump-sum purchases.

2) Avoid long-term fixed-income commitments (long-term bonds, long-term cd’s, fixed annuities without an inflation rider).

3) If you own a house, look into refinancing or re-re-re-refinancing your mortgage.

4) If you’re renting, you live in an area where house prices are reasonable in relation to rent, and you have enough money for a 20% down-payment, consider buying a house. I’ve been very patient in delivering this message but my confidence is now fairly high that affordability (based on the mortgage payment you’d expect given home price and interest rate) will peak by Spring ’13.

Most of all, stay alert and stay flexible. Today’s announcement is unprecedented and therefore at least partially unpredictable. Bazookas are powerful, but they’re not the most precise weapon and they may have some collateral damage. If we’re using imprecise, extremely powerful, and somewhat unpredictable tools to try to control the economy, the result, well, let’s just say this is probably not the final chapter of this economic cycle.

The Marriage Penalty

No, I don’t mean the price of dealing with your spouse on an every-day basis as many sitcoms illustrate (frankly, I don’t consider that a penalty at all in case you’re reading this, honey!). I’m talking about the “features” built into the tax code so that a married working couple pays more tax than the same two working individuals would if they were not married. Few people understand this, but it can have a really big impact on your taxes when you get married and starting in 2013, the impact will be even bigger.

Let’s start with the most basic form of the marriage penalty, the tax brackets. Table 1 shows the starting income level for each 2012 income tax bracket for both the single and joint filer. As I described in Am I Working Too Much, a taxpayer pays tax at the rate indicated in the table for each bracket. For example, a single taxpayer would pay 10% tax on her first $8,700 of taxable income + 15% tax on her next $26,650 of taxable income up to $35,350 + 25% on her next $50,300 of income and so on. A married couple would pay tax in the same manner using the married tax brackets. Notice that while for the lower tax rates, the married bracket is two times the single bracket, the higher your income, the faster the married tax brackets increase vs. the single tax rates. This closes the gap between the married brackets and single brackets slowly until they are identical once reaching the top tax bracket. Let’s use an example to see the impact on two individuals, each with $150k of taxable income who get married. As single filers, they each pay 10% of $8700 + 15% of $26,650 + 25% of $35,350 + 28% of the remaining $64,350 for a total tax bill of $35,461 each or $70,922 in total. As married filers, using the married part of the table and a similar calculation, they’d pay $75,907 in tax. This additional ~$5k of tax is the most basic form of the marriage penalty. Note that electing to file Married Filing Separately does not reduce the marriage penalty since the MFS brackets are not the same as the Single brackets. Instead they are ½ of the Married Filing Jointly brackets. Additionally, it is not legal to file as a single taxpayer if you are legally married so you can’t just choose to file Single. To make things worse, starting in 2013 after the “Bush tax cuts” are eliminated, the multiple for the 25% tax bracket will be 1.67, instead of 2 as it is today. That will compress the 25% tax bracket for married filers down to $58,900 and add another few hundred dollars of tax.

There are other forms of marriage penalty in the tax code as well, some in existence now and others coming back in 2013 after the Bush tax cuts expire:

· For those claiming the standard deduction, the married standard deduction is currently $11,900, exactly twice the single deduction of $5,950. Starting in 2013 though, the old standard deduction marriage penalty kicks in here too with the standard deduction for married filers reverting back to ~1.67 times the single deduction (would have been $8700 for 2012).

· The qualifying income level for the Earned Income Tax Credit for married filers is less than 2x the Single levels.

· The new healthcare reform taxes starting in 2013 on investment income and earned income only impact those single filers with income up to $200k, but hit married filers starting at $250k per year in income).

· For those paying the Alternative Minimum Tax (AMT), the personal exemption for a married couple is less than 2x the Single level.

· The reduction in itemized deductions and personal exemptions which is due to return in 2013 will start at an income level for married couples that is less than twice the single income level.

· The threshold for determining whether a married couple’s social security benefits are taxable is substantially less than 2x that of a single filer.

· Multiple other deductions, credits, and exclusions in the tax code phase-out for married couples at less than 2x the single level including deductible IRA contributions, Roth IRA contributions, the Child Tax Credit, the deduction for capital losses taken in any one year, and the deduction for current year loss on a rental property.

More to come on the marriage penalty in future posts regarding 2013 tax changes.