That seems truly insidious, but it’s very misleading.

The effect of zero-expected inflation on income

With no long-term expected inflation, retirees should expect to earn 2% less on their portfolio because the nominal long-term bond yield generally reflects the real long-term interest rate plus long-term expected inflation. Then their annual interest should be $30,000. So, no need to worry. Wrong.

The effect of income taxes on inflation-caused ‘phantom’ income

Inflation causes additional income taxes on the additional $20,000 in “phantom” income caused by the inflation. Assuming the retirees live in California and also receive $25,000 in Social Security ($75,000 total income), the additional taxes are about $3,700. That means their spendable income from their portfolio has decreased about 12% from $30,000 to $26,300. 

If they have some stocks in their portfolio, the decrease is less because dividends and capital gains are taxed more favorably. Using Vanguard’s asset allocation in its Retirement Income EFT Portfolio (VRIF) of 30% stocks and 70% bonds, the decrease is about 8% or $2,400. These are substantial losses of spendable income.

The decrease in spendable income rises substantially as portfolio income increases, even with a 30% stock allocation: with $100,000 in portfolio income ($125,000 total income), it is about 10% or $6,000; with $225,000 ($250,000 total income), it is about 23% or $27,000.

The insidious impact on homeowners

Home ownership is one of the goals of most families. In the United States, about two-thirds of households own their own home, but about 65% of those who do not own a home — roughly 28 million households — would like to. About half of these households cannot afford the mortgage payment, and about 60% lack the down payment. That means there may be up to 9 million households that might be able to buy a home if mortgage rates were substantially lower.

Likewise, many of the 87 million homeowners who later buy a bigger home when they can afford the higher mortgage payments may have been able to buy that bigger home when they bought their first home, and could have avoided the costs of selling their first home and moving to a new home.

Over the last 25 years, the average fixed mortgage rate has been about 5.1%, and the average inflation rate has been about 2.6%. That means that the real 30-year fixed mortgage rate has averaged about 2.5% (5.1%-2.6%). That implies that the fixed mortgage rate with 2% expected inflation would be about 4.5%, and with no expected inflation would be about 2.5%. Monthly mortgage payments would be 20% less. For instance, a $500,000 mortgage would have monthly payments of about $2,000 instead of $2,500, $500 less. That is a substantial reduction.

The solution

The best solution is for the Fed to reduce its inflation target to zero or near zero, which is what the term “price stability” really means.

On the St. Louis Fed website, the Fed gives three primary reasons why it is better to target inflation at 2% rather than zero:

Measurement bias: Economists have estimates that the Consumer Price Index (“CPI”) overstates true inflation by 0.5% to 1.5%. However, the Personal Consumption Expenditures (“PCE”) index used by the Fed is estimated by economists to only have an upward bias of a few tenths of a percent. So, this reason only implies a need for about a 0.25% inflation target.

Room to cut interest rates: Because a higher inflation rate tends to cause a proportionally higher nominal interest rate, a 2% target gives the Fed more room to cut interest rates in the event of a recession to stimulate economic activity. It is true that reducing rates by an additional 2% can help fight recession. 

However, doing so actually destabilizes interest rates, the price of borrowing money. Destabilized interest rates have very significant adverse effects on the economy, such as undesirable booms and busts in the housing market and the stock market. If reducing non-inflated interest rates to zero is not enough to fight off a recession, fiscal policy should be used.

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Avoiding deflation: In the last 100 years, the only significant deflationary period was during the Great Depression, partially caused by the Fed policy of maintaining significant nominal interest rates to prevent a run on gold. In 1931, the third year of the depression, the Fed increased interest rates by 2% to stop a run on the U.S. gold reserves. As a result, real short-term interest rates were over 7% on average during the first four years of the Great Depression, compared to a 100-year average of around 2%, and by far the highest ever in the U.S. Today to combat potential deflation, the Fed would not hesitate to force short-term interest rates down to zero. If that does not stop the deflation, then fiscal policy should be used. Avoiding deflation seems like a minimal risk compared to the real problems caused by the 2% target.

The Fed’s goal, besides maximum sustainable employment, should be financial stability, which should include not only stable consumer and producer prices, but also stable interest rates. Furthermore, it should include asset prices of stocks and real estate that are not artificially affected by volatile interest rates caused by Fed policies.

Davis D. Thompson received M.A. and M.Phil in economics from Yale, a J.D. from UCLA, a Masters in Business Taxation from USC, and a B.A. in economics for Santa Clara U. He is currently a registered investment advisor.