Economic recovery faces serious hurdles

As the U.S. economy rounds the midyear turn, most economists believe that growth will resume as early as the current quarter. They are trying not to let you see that they are saying this with their fingers crossed.

Several months ago, it looked as though the economy was in the process of bottoming out. A number of statistics had begun to point up, not the least of which was the stock market, considered by many to be a venerable leading indicator.

From the middle of March until the middle of June, stocks went on a tear, rising more than 30% -- the biggest jump in such a short period of time since the 1930s.

It is an open question why stocks rose as much as they did -- especially since they have gone nowhere over the past few weeks. Some believe that stocks fell too far, while others think the market was anticipating a turn in corporate profits as early as the third quarter.

Whatever the case, it should be pointed out that even with this big run-up, stocks, as measured by the Dow Jones Industrial Average, are still below their levels at the turn of this year -- much less a year ago, when the Dow was just below 12,000, and 21 months ago, when the Dow peaked at 14,165.

This has a direct bearing on the economic outlook and whether the market's expectations will come to fruition. Stocks at today's levels represent a tremendous loss in investors' net worth. This alone has been enough to put the kibosh on consumer spending, which represents 70% of the gross domestic product.

Another depressant holding back the urge to splurge is the drop in residential real-estate values. For many, a home is their biggest asset, and lower prices alone are enough to cause people to pull in their horns. Add in their inability to pull money out in the form of a home-equity loan, and the prospects for spending gains become even dimmer.

To add insult to injury, the price of oil and gasoline has been on the rise since the beginning of this year. Although well below levels a year ago, when prices peaked at more than $4.00 a gallon nationwide, gasoline still costs about 60% more today than it did six months ago, making it difficult for many households to buy other goods and services.

Spending is also being constrained by a decision on the part of many households to rebuild their depleted bank accounts. The savings rate has gone from zero to a 15-year high of nearly 6% -- and they are earning very little on their savings, due to today's record low interest rates.

On top of this, falling employment and rising unemployment are also exerting a drag on consumer spending. And if the past two recoveries are any guide, it could take a year or more after the economy turns before employers will resume hiring.

As for Washington's stimulus package, very little has hit the economy so far -- as I first pointed out in my column of May 26 and reiterated last week. Indeed, when you factor in cutbacks at the state and local level, you could almost say that fiscal policy has actually tightened over the past year.

Even the turnaround in business productivity is nothing to cheer about. What good is it to be more efficient if you don't have many customers coming through the door

8 Tax Strategies to Consider in 2010

With minimal effort, you can still have a huge impact on your 2009 tax return by decreasing your realized income. If any of these strategies appeal to you, speak with a tax adviser, pronto.

Strategy #1: Fund your Retirement:

You may still be able to add more contributions for your 401k in 2009.

Additionally, you will be able to make tax deductible contributions to a traditional IRA up until the 2009 tax filing deadline (April 15, 2010) for the 2009 tax year. The IRS maximum allowed 401k limit is $16,500 in both 2009 and 2010. For those 50 and over, the catch-up contribution brings you up to $22,000 both years. For IRA’s, the limit is set at $5,000, while the catch-up is $1,000 for both years. Check with your employer ASAP to see if it’s not too late to kick up your contributions.

Strategy #2: Hold Off on the Roth IRA Conversion:

Owners of traditional IRAs can convert all or a part of their accounts to a Roth IRA if their 2009 modified adjusted gross income is under $100,000.

Any amount converted is taxable income, but is thereafter eligible for the potential tax-free distribution rules of Roth IRA’s. The big news is that starting in 2010, the $100,000 income threshold is removed – anyone can do a conversion. For 2010 only, you also have the option to spread the income from conversion over the following two years (2011 and 2012). Many have been waiting for this opportunity.

Strategy #3: Sell Losing Investments (and Big Winners):

The S&P 500 index went from the low 900’s to a low of 666 (funny number,right?) in March, back up to a 2009 high of 1,119. That’s one heck of a volatile year. All in all, the market is up over 22% for the year. Depending on when you’ve bought and sold, you might want to consider unloading big winners to offset your losers, or big losers to offset your winners. First, you must subtract your losses from any capital gains you’ve made. Next, additional losses can offset up to $3,000 of your 2009 ordinary income. Have larger net losses than $3,000? Losses above and beyond what you used to offset your capital gains and ordinary income can be carried over into future tax years. Before implementing investment loss strategy by selling mutual funds, make sure that you won’t incur any penalty for holding shares for too short of a period of time.

Strategy #4: Capital Gains Tax Cuts:

Under the Tax Increase Prevention and Reconciliation Act (TIPRA) of 2005, US taxpayers in the two lowest tax brackets (10% and 15%) will pay no capital gains taxes on long-term investments sold in 2009 and 2010.
Long-term capital gains result from profit made via appreciation of a security (stock, fund, etc.) held for more than one year.


Strategy #5: When you Donate to a 501(c)(3), Everyone Wins:

Tax deductions for charitable donations can be claimed for the year in which the donation is made. Perhaps it’s time to rummage through your house to find valuables you no longer need or want that others can gain value from. You may obtain fair market value on these items. Or, simply open your checkbook or donate cash. Donations of $250 or more must come with a written receipt or letter from the 501(c)(3). When submitting your donation, ask for and keep all of the appropriate documentation and receipts associated with all donations so that you are safe in the event of a possible future tax audit. If you are donating goods, document a description of everything given.

Strategy #6: Prepay your January, 2010 Mortgage:

If you’re a homeowner, you may want to consider making your January mortgage payment in December, which will give you one more month of interest to deduct from your 2009 taxes. Check with your mortgage provider to see if an early payment is possible. It may be a great way to offset extra income windfalls in 2009.

Strategy #7: Get Healthy on your Medical Bills:

If you have have large and predictable medical and/or dental bills that need to be paid, consider making all the payments before the year is over. The IRS allows families to itemize and deduct medical and dental expenses that exceed 7.5% of their adjusted gross income, so if you’re close to going over that percentage it may be wise to pay the bills to be able to make the deduction.

It won’t affect your 2009 taxes (since it was already deducted), but don’t forget to use up the rest of your 2009 FSA funds if you are in danger of losing them in the new year.

Strategy #8: Prepare for 2010:

Using Mint.com to classify all of your deductible expenses in 2010, can allow you to tag anything as tax related. Download your transactions to a spreadsheet and send it to your accountant. If you’re doing your own taxes, this info will give you a big head start in using online tax software, such as TurboTax, which offers federal filing free. If you expect that you’re due a hefty refund, file asap, so that you can get back your return and re-invest it. Also, speak with your employer about your withholding taxes if you have found that you owe too much taxes or are getting a large refund.

Why should Fed raise the rate now ?

On October 9, 2009, the Financial Times reported that the Fed was testing a key tool for draining liquidity from the financial system. Ten days later, the Fed confirmed that it had in fact been conducting reverse repos, but the tests were not an indication of a change in monetary policy.

That same day, a Barron's cover article appeared, sharply suggesting Fed chairman Ben Bernanke should already be raising rates and removing liquidity. The article cited that gold, oil and other commodities, as well as the stock market were are already rising, and that the dollar was falling. These are all signs of excess money in the system.

Clearly Fed is aware that it will need to remove the excess liquidity and raise rates in the future. But at this point, it's not exactly sure, or it isn't saying, when that will be, and it's staying the course despite the calls to do otherwise. This is the smart strategy, and here's why.

A Difficult Balancing Act
The mandate of the Federal Reserve is simple to understand, but complicated to accomplish. It desires stable prices and low unemployment, a difficult balancing act to say the least. The most important thing is stable prices, hopefully rising slowly at around 3% per year. This allows growth without excess inflation. Also, it is more important to fight inflation than high unemployment as inflation hurts everyone. Unemployment, even at today's high levels, impacts far fewer people. So first things first, stable prices, then low unemployment.

When inflation is low and unemployment is high, the focus is on increasing economic activity and reducing unemployment. This is the situation today. So, while the signs of potential inflation are taking shape, higher stock market and commodity prices along with a lower dollar, prices of goods and services haven't been rising very much, if any. Until this changes, it's likely the Fed will stay the course and not raise rates.

Differing Goals
The goals of the pundits can differ from this. They can call for a stronger dollar - making that their primary goal. The problem with that is the moves to increase the value of the dollar would likely slow the economy and increase unemployment. So it would be at odds with the Fed's goals. Other pundits may desire leaving the excess liquidity in the system to push the market rally even further. Again, that isn't the Fed's goal. The Fed decision making doesn't stray too far from its mandate of stable prices and high employment. To do so would risk not accomplishing one, or possible both, of those primary objectives. While others may suggest policy shifts to push their goals, it's unlikely the Fed will listen.

Another major difference in the Fed and the pundits is that the Fed typically needs to see evidence that something is happening before it acts. The pundits espouse a future that may or may not come to fruition. It's the difference between thinking we are going to have inflation, and actually having it. This lag can drive those that were correct crazy, but it's the only sensible course of action. The alternative would be to have the Fed try to anticipate economic activity before it occurs and act to offset it. The Fed correctly leaves the reading of the tea leaves to the tradder and pundits and acts based on evidence, not projections.

Careful Planning
Also, the Fed is keenly aware of the importance of the message it sends to the markets. It's crucial that confidence in its leadership be maintained and that it doesn't send mixed messages. A confused market creates panic. Typically, interest rate moves by the Fed have been in small, steady increments, and changes in direction were clearly telegraphed so as not to shock the markets. However, on the rare occasion when the Fed wants to get the market's attention, it has moved interest rates between meetings and in larger increments. That's very unlikely here.

Most firms don't hire people until demand for their products and a service exists, so employment is typically a lagging indicator of economic activity. In other words, firms need to sell more products and services before they hire more people. And, of course,selling more products and services can be inflationary. Therefore, the most likely course from here is that inflation will increase before unemployment totally subsides.

Future Fed Moves
Though the Fed is staying put right now, it's very likely that it will be raising rates and reducing liquidity before strong employment returns. But it won't take this action because of an article in a paper, or a pundit on television. It will need to see evidence of prices rising before it raises interest rate. But once the Fed does see that evidence, the pieces are being put in place already, and it will act.