Health reform legislation portends higher inflation

Although the Federal Reserve Board remains confident that inflation will remain low, those drafting the health reform legislation in the House of Representatives appear to be betting that it will accelerate in the next few years.

They have decided to pay for much of the cost of the health care reform bill by increasing taxes on individuals who earn more than $500,000 a year and couples earning more than $1 million a year. However, the reformers have failed to index for inflation the income levels at which the higher tax rates will begin.

This means that if there is inflation, cost-of-living pay increases will push more and more Americans, including middle-class taxpayers, into the new income tax levels, boosting revenue.

This is the same trick that Congress used when it passed the alternative-minimum tax, which was supposed to affect only millionaires who, because of loopholes, paid no income taxes. But because of the lack of indexing, each year, millions of middle-class Americans are threatened with having to pay the higher AMT rates.

Each year, Congress has to pass an emergency fix to prevent those millions from actually seeing a huge jump in their income tax obligations.

The House’s financing plan may not pass, as the Senate appears to be considering other ways to finance the reform, but it is a clear indication that some in Congress would not mind a little inflation to help government out of its financial bind.

This should serve as a warning to all financial planners and investment advisers that they should prepare their clients, and their clients’ investment portfolios, for the possibility of higher inflation.

Throughout history, governments have used inflation to relieve the burden of government debts, the most famous example being Germany’s Weimar Republic between the two world wars, where easy-money policies, driven in part by the need to repay American loans that it had used to pay war reparations, caused hyperinflation.

No one in Congress is likely to deliberately countenance policies that would bring about hyperinflation, but some clearly would like at least a little inflation.

The task for planners and advisers, of course, is to position their clients so they won’t be hurt by inflation.

Those most at risk in an inflationary scenario are those in retirement. The purchasing power of their income is unlikely to keep pace with inflation unless their assets are carefully invested in asset classes that automatically adjust for inflation, such as Treasury inflation-protected securities.

Unfortunately, TIPS yields are low at present, making it difficult for all but the very wealthy to generate enough income from them to live on.

For most clients, planners and advisers will have to examine the full range of inflation-offsetting investments and strategies. These may include some TIPS, stocks (especially commodities stocks), Treasury bills and money market funds — the yields of which have moved up close behind inflation and commodities.

It may also be time to consider converting regular individual retirement accounts into Roth IRAs, since higher inflation may be accompanied by higher income tax rates. Beginning in 2010, that will be possible for more clients as the income limitation on such conversions disappears.

The Federal Reserve may indeed pull off a recovery without significant inflation, and the Obama administration and the Treasury may be able to devise a plan to pay down the deficit.

However, if some leaders in Congress are rooting for inflation, it probably isn’t wise to bet against them.