Thursday, December 9, 2021

Record-setting gains in wealth threatened by rising inflation

Today the Federal Reserve released its estimate of the balance sheet of US households (which includes non-profit organizations) as of Q3/21. It's basically a summary of the assets and liabilities of the US private sector. Once again, things look better than ever. Private sector net worth now stands at a record level of $144.7 trillion. That's up 24% (+$28 trillion!) since just before the Covid crisis hit, and it's up 105% since just before the 2008-9 Great Recession. Financial assets top the scorecard, with a gain of 111% since their 2007 peak. Tangible assets are up 55% since their 2006 peak.

Chart #1

Chart #1 shows the evolution of households' balance sheets over the past 20 years. What stands out the most is the relatively small increase in household liabilities. They are up only 21.% since their 2008 peak. Meanwhile, net worth has more than tripled in the past 20 years, up from $45 trillion to now $145 trillion. 

Chart #2

After adjusting for inflation, we see that over the past 70 years, households' net worth has increased eleven-fold! A caveat, however: note how net worth has moved above its long-term trend line. This could be a replay of what we saw in 2000 and 2007, when some markets got very overextended. By that I mean that for the next several years a mere reversion to trend would mean very modest returns for investors.

Chart #3

After adjusting for inflation and population growth, net worth has sextupled (see Chart #3), soaring from about $72,000 to now $432,000. That works out to annualized gains of more than 2.3% in real, per capita net worth. Same caveat as with the prior chart: the blue line has moved substantially above its long-term trend. 

Chart #4

Not only are households wealthier than ever by any measure, their finances have improved dramatically relative to the peak of Q1/2008. Leverage (total liabilities as a percent of total assets) has plunged by 43%, and now stands at levels not seen since 1973. This wealth boom was not debt-fueled, as was the boom that occurred from 2002 through 2008. Private sector finances are on solid ground. This mitigates some of the fears that I refer to in the previous charts. Also bear in mind that short-term interest rates are extremely low, as are real yields. Those rates are not the sign of irrational exuberance; investors are paying huge multiples for safe assets (e.g., the PE ratio of a 10-yr Treasury is about 70).

Chart #5

Ahhh, but you say, isn't the federal government in debt up to its eyeballs? In a sense yes: federal debt outstanding was an astounding $23.2 trillion at the end of Q3/21, up 30% since the end of 2019 (+$5 trillion), making it equal to 96% of GDP. But the burden of that debt (interest payments as a percent of GDP) was as low as it's been for many decades, as Chart #5 shows. Federal debt is astoundingly large, but it's quite manageable.

But, you say, isn't the burden of federal debt going to skyrocket when interest rates go up, as they surely must, given the elevated level of inflation? Not necessarily. In fact, we will likely see a huge reversal of fortunes in the years ahead. The government has leveraged up as the private sector has leveraged down, but leverage—especially when interest rates are extremely low relative to inflation—is not always a bad thing. Also bear in mind that even if market interest rates soar, the average maturity of federal debt is 7-9 years, so total interest costs on the debt will only rise slowly as low-interest debt matures and is replaced by higher-interest debt. In contrast, federal revenues will soar as inflation rises (inflation boosts incomes, and that in turn boosts tax revenues), and we're already seeing that: in the 12 months ended this past October, federal revenues were up 18% relative to the same period two years ago (i.e., before the Covid crisis). That's an extremely fast pace of revenue growth. Of course, what's good for the federal fisc is bad for the taxpayer, since he/she will be paying a hefty inflation tax as their incomes push them into higher tax brackets. 

Furthermore, the federal government stands to benefit enormously in coming years as high inflation and very low interest rates effectively transfer wealth from the private sector to the public sector. This could be the driver of below trend growth in household net worth in coming years. As Chart #2 and #3 suggest, real net worth is significantly above its long-term trend, so a reversion to trend would mean much smaller gains in the years ahead. In fact, it would not be surprising to see net worth fall below its long-term trend, as it did during the high-inflation 1970s.

With inflation running at 7% and the average interest rate on existing federal debt outstanding running just over 2%, the real value of federal debt is currently declining by about 5% per year. In other words, inflation is subtracting over $1 trillion of the real value of federal debt outstanding every year at the same time inflation is boosting government revenues and nominal GDP. This means that the private sector is effectively paying an additional $1 trillion per year in taxes to the federal government (aka the inflation tax). 

If I were a cynic, I would argue that the Fed's easy money posture is perfectly designed to bail out the federal government. I've seen this happen time and again in Argentina.

In any event, don't cry for the federal government; it will do just fine. It's taxpayers who will suffer from rising inflation.

UPDATE (12/10/21):

Chart #6 shows federal revenues by source, updated with the November figures released this morning. Note the huge jumps in individual income tax and corporate income tax. Payroll taxes are flat to slightly down, because total payrolls are still 4 million below what they were pre-Covid (Feb. '20). Chart #7 shows total spending and revenues. Both charts use a rolling 12-month sum. Although spending is through the roof, at least it is declining and should decline further in the months to come, thus further narrowing the deficit. The 12-month deficit peaked at $4.1 trillion as of Mar. '21, and over the 12 months ending Nov. '21, it fell to $2.7 trillion. Things are headed in the right direction, thank goodness, even though the situation is still far from normal. 

Chart #6

Chart #7