Sunday, November 4, 2007

Real Interest Rates After Taxes

This chart shows the real interest rates on the 1-year treasury after taxes (taxed at 35%).

For example, the most recent data point represents a 1-year treasury purchased in September, 2006 and held until September, 2007, paying 35% tax on the gain, then adjusting the return by the amount the CPI-U increased from September, 2006 to September, 2007.

Note that high inflation periods such as the 1970s become especially brutal to savers, but much of it simply reflects the extra tax on the higher interest rates.

If you earn 3% and lose a third of it to taxes, you are left with 2%. That's a 1% loss adjusting for 3% inflation (1.02/1.03 = 0.99). It hurts, but you probably won't notice it all that much in the short-term.

If you earn 15% and lose a third of it to taxes, you are left with 10%. That's a 4.3% loss adjusting for 15% inflation (1.1/1.15 = 0.957). That hurts a lot. If you keep doing that year after year, your savings will be gone before you know it.

This pain isn't just limited to individual savers though. It also affects companies in much the same way (see a link to Warren Buffett's thoughts below).

If negative real interest rates drive commodity prices higher and that triggers a form of stagflation, then we've recently been subjected to stagflation-lite. Is the stagflationary pain actually over though? The word stagflation actually came into being in 1965. What if we are repeating the 1965-1980 era? What if we're just getting warmed up for an even more serious dose of stagflation yet to come? That's my concern in the long-term, especially if the apparent housing bubble continues to pop.

There is no excuse for a strong, healthy economy to produce negative real rates of return. If we are getting them, then something is broken. In this particular case, it was the ever so slightly broken dotcom bubble, spewing shards of anti-prosperity in the faces of anyone bothering to look. The government, in sheer panic/terror, drove interest rates so low we'd have to buy something. Well, we did. Investors bought stocks, commodities, precious metals, oil, and houses in response. I think that is fairly clear. Those that saw the true source of the bull market and went after the hardest asset classes did the best generally. Stocks (paper) did not outperform gold (rocks) and most certainly did not outperform oil.

At this particular moment in time, I'm not all that stagflationary even in the face of $90 oil. Real interest rates seem fairly reasonable. I'm leaning a bit deflationary. I think peak oil is real, but I don't think this is necessarily it. I don't think it was a coincidence that all assets moved higher together. I'm not bullish on housing right now, so it is very difficult for me to want to hoard other hard assets.

Of course, these are just my opinions again. Opinions and a quarter will buy you a cup of coffee. That's assuming it is a generic 1964 quarter (worth $2.50 due to its silver content alone) and you buy the coffee at McDonald's. If you have one of those new state quarters (with no precious metal content at all) and are buying your coffee at Starbucks, good luck on that one!

As for the value of the opinions, they're 100% free and probably worth what you paid for them. I'm very uncertain these days.

See Also:
Real Interest Rates
Warren Buffett on 1970's Inflation

Source Data:
FRB: Selected Interest Rates
St Louis Fed: Consumer Price Index For All Urban Consumers: All Items

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