The Upsides of High Inflation

Nobody likes high inflation. My wife has been cringing at what it costs to eat out these days. A local place we like is charging $17 for a salad. It is both a good and generously portioned salad, but $17 is still surprising for a casual, suburban eatery.

While I’m certain that you too have noticed prices on many other items become much higher than they used to be, there are some upsides to the high inflation.

I’ll start with stocks, given that we’re experiencing another bout of downside volatility. Stocks have historically performed well once inflation has peaked. “Since 1927, the average S&P 500 return in the 12 months following an inflation crest was 11.5%,” wrote Tony DeSpirito, a chief investment officer with BlackRock, in a report this week.

He went on to say that “value stocks have a history of outperforming growth amid high (4.5% and above) and even moderate (1.1%–4.4%) inflation.” There may also be an opportunity in terms of combining growth and value. Russell 1000 index companies with a 50/50 mix of growth and value outperformed the market following four of the six inflation peaks since 1978, according to DeSpirito.

Bond Yields Are Higher

Bond yields are higher as the Federal Reserve has raised interest rates to combat inflation. This has created an opportunity for income-seeking investors to lock in bigger coupons than they have been able to get in quite some time. And, yes, those coupons could get even bigger as the Fed continues to raise interest rates.

What’s surprisingly not being talked about is U.S. Treasury Series I bonds. I bonds issued through next month (October) yield 9.62%. The fixed rate on these bonds is 0.0% and the semiannual inflation rate is 4.81%. When the next rate reset goes into effect in November, the inflation segment will be adjusted on the non-seasonally adjusted consumer price index (CPI) for all urban consumers (CPI-U) for all items. Those who currently own I bonds, like me, will get the inflation adjustment—which I expect to still be juicy.

New I bonds issued starting in November may also have a fixed rate above 0.0% given the Fed’s rate hikes. How much above 0.0% remains to be seen, but the increase will add to the yield paid by new I bonds.

Keep in mind that there is a $10,000 per person per calendar year limit on buying electronic I bonds. The inflation component can be reduced, and future yields may be lower than they are now. You can sell I bonds after one year, but you will forfeit the last three months of interest if you sell your I bonds within five years of purchase.

Treasury inflation-protected securities (TIPS) are also paying more in income. The principal on these bonds adjust to inflation. Higher rates of inflation mean bigger increases to these bonds’ principal amounts, and the adjustments are cumulative. (We’ll have a new article about TIPS in the November AAII Journal.)

Yields Are Higher on Savings Accounts Too

Yields on savings accounts, money market accounts and certificates of deposits (CDs) have risen. AAII members can earn 2.15% on their savings through our affinity program with Discover, for instance. These higher rates, while welcome, are still lower than what one should expect from a long-term allocation to stocks. Safe assets like these are meant for short-term and emergency savings, not for money intended for long-term goals.

Tax Adjustments Could Be Welcome News

Finally, the next year’s tax adjustments may come as welcome news. Bloomberg Tax is projecting an approximate 7.1% increase in inflation-adjusted tax limits, exemptions and deductions. An example is the standard deduction, which could rise from $25,900 to $27,700 for married joint filers. The maximum limit for qualifying for the 0% capital gains rate could rise to $89,250 for married joint filers as well.

These are projections; the Internal Revenue Service (IRS) should announce the actual adjustments in November. Our tax guide, included in the December AAII Journal, will list the key 2023 tax numbers you will need to know.