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How Fed incompetence will drive inflation higher

Getting my in-laws out of Ukraine last year felt like it was as complicated as planning the Normandy invasion.

My wife is Ukrainian, and her family had been stuck in Kiev since the start of the war. For months leading up to the invasion, they ignored the Russian troops massing on the border and casually rejected my offer to fly them out of the country.

But then the shooting started… and it was pure pandemonium in Kiev. The airport closed, many roads were closed, the trains were full, and key border crossings were locked down.

The only reason we were able to get them out of the country at all was because my wife and I recently had both of our children in Mexico. And as I’ve written before, any child born in Mexico automatically becomes a Mexican citizen at birth… PLUS the parents and both sets of grandparents receive permanent residency.

So, as grandparents to my kids, my in-laws were eligible for Mexican residency. It was a ton of effort to process their paperwork through a war zone, and then figure out the logistics of actually moving them… but we were ultimately successful and got them out.

Their first stop, unsurprisingly, was Mexico. My wife and I were still in Cancun at the time as my son had just been born. But within a month or so, we returned back home to where we live in Puerto Rico, and my wife’s family came with us.

This is where the real pain began… because I wanted to set them up with their own house– for their privacy, and mine.

But finding a place to rent in Puerto Rico– especially last year– was about as complicated as… well, moving a Ukrainian family out of a war zone.

Housing supply started becoming very tight across the entire United States ever since the summer of 2020. And this is especially true in Puerto Rico.

I’ve written before that Puerto Rico boasts several extraordinary tax incentives; it’s one of the only places in the world where US citizens can move and NOT pay a dime of tax to the federal government.

This isn’t some loophole or illegal tax evasion; it’s the LAW. While Puerto Rico is a US territory, the island has its own tax law. And US federal tax code (section 933) clearly states that personal, business, and investment income sourced in Puerto Rico is excluded from US federal income tax.

Instead, we’re subject to Puerto Rican tax rates. And thanks to the generous incentive programs, those tax rates are as low as ZERO. It’s incredible.

Naturally a lot of people residing on the US mainland realized that 0% tax rates were incredibly attractive. So a LOT of folks started moving here to Puerto Rico back in 2020 and 2021.

But Puerto Rico is a small island, and there’s very little housing supply. So the sudden influx in expats caused an unbelievable surge in home prices. And if you think Florida real estate got pricey, you should really see Puerto Rico.

The highest-end communities on the island reached prices that have only been seen in Monaco and Hong Kong.

But even in Puerto Rico’s more modest neighborhoods, home prices went through the roof. So did rents.

It was under these market conditions that I had to find a place for my in-laws to live… so even people with dilapidated, poorly maintained homes acted as if they owned the Taj Mahal.

Now, Puerto Rico’s exuberant property market is the result of some unique supply and demand circumstances (which are finally starting to cool off). But the rest of the United States has seen plenty of housing insanity too.

And it’s still going on.

Remember, the Federal Reserve is supposedly pulling out all the stops right now to tame inflation. And as part of that campaign, they’ve been aggressively raising interest rates for more than a year without any regard or even awareness for the consequences.

Just three days before Silicon Valley Bank’s collapse back in March, the Chairman of the Federal Reserve told Congress that everything in the financial system was just fine.

Yet SVB went bust (three days later) in large part BECAUSE of the Fed’s interest rate hikes; the bank had bought $120 billion worth of US government bonds, most of that in 2020 and 2021.

Now, US government bonds are supposed to be the ‘safest’ asset class in the world. But even government bonds lose value when interest rates rise; this is the immutable law of the bond market– when rates go up, bond prices fall.

But the Fed didn’t see it coming. They didn’t realize that their rapid interest rate hikes would wipe out banks’ bond portfolios, triggering a wave of insolvencies.

Similarly, they failed to anticipate back in early 2020 that printing trillions of dollars to stimulate the economy during the pandemic would create inflation.

This shouldn’t have been hard to predict. I predicted it. So did a lot of other people. But the Fed totally missed it.

Later they insisted there would be no inflation. Then they wrongly predicted inflation would be ‘transitory’. Then they admitted “how little we understand about inflation”, which is frankly terrifying.

And now they’re raising rates under the foolish assumption that this will solve the problem… proving that the Fed STILL does not understand inflation.

Inflation is the result of a number of complex factors. For example, the Biden administration’s crusade against capitalism has deliberately targeted oil companies. And gee, what a surprise, oil prices have risen considerably as a result of tightening supply. This is a huge driver of inflation.

Conflict is also very inflationary, and there’s plenty of that in the world. During times of peace, economies allocate resources towards productive investments. Trade flourishes. Prosperity booms.

During times of conflict, however, economies allocate towards destruction. Trade wanes. Central banks print a lot of money. And the result is typically higher prices for scarcer goods.

There are also major demographic trends at work. Millions of Baby Boomers are retiring, reducing the number of productive workers in the economy. And it’s the same story with Generation Z, which has millions of people who simply never entered the work force to begin with.

But raising interest rates won’t change any of these trends.

Raising interest rates won’t suddenly turn Joe Biden into an articulate, sagacious philosopher-king. Raising interest rates won’t stop the war or make China back off.

Ironically, though, raising rates CAN actually make inflation worse. And housing is a great example.

In March 2021, the median US existing home sale price was about $273,000 according to Zillow. The national average 30-year mortgage rate back then was 2.96%. So with a 20% down payment, the monthly mortgage on a median (middle class) home in America would have been $924.

Today, the median home sells for about $339,000. With 20% down and a 6.35% interest rate, the payment is now $1,704 per month… 84% higher than in 2021.

This is extremely inflationary.

It might not show up in the official statistics given the squirrelly, dishonest way that the government calculates housing inflation.

But when there are 4 million families in the market to buy a home right now (according to the National Association of Realtors) whose housing costs will soar by 84%, it’s hard to argue this won’t contribute to inflation.


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Wealthfargo
Wealthfargo

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