The Pros and Cons of High Inflation

Inflation is the loss of purchasing power over time, meaning that your money buys less than what it did in the past. Historically, inflation has averaged approximately 3% per year. However, we’re in an extremely high inflationary period right now—over the 12 months that ended June 30, 2022, the Consumer Price Index for All Urban Consumers (CPI-U), a measure of inflation, increased 9.1%, the highest level since 1981. Causes include pent-up demand for travel, entertainment, and other goods and services that were verboten during the pandemic, supply-side shortages, supply chain disruptions, and disruptions in food and energy triggered by Russia’s war on Ukraine.

Many factors can drive high inflation, including high consumer demand. Pandemic assistance payments and reduced spending at the beginning of the pandemic put more money in the hands of millions of consumers, who are now spending it. When demand increases, so do prices. As a result of supply chain issues, the prices of many goods and services have increased as well.

Everyone should have an emergency cash reserve, and we generally recommend targeting 3 to 6 months of expenses for this. Depending upon your goals and stage of life, you may need higher cash reserves. Revisit The 4 Ws of Cash Management for additional guidance and recommendations.

When inflation is high, that’s good news for people who have large cash reserves and bad news for people on a pension, and for home buyers who want to take out a mortgage. Below are a few items affected by high inflation that may have a good or not-so-good impact on your wealth.

The Good

  • Interest rates on money market funds have risen. This is great news for people with large cash reserves. We are working with clients to move cash reserves to a purchased money market fund to earn a higher interest rate.
  • Federal income tax brackets, the bucket of taxable income that corresponds to a given tax rate, will be wider for 2023, since the brackets are annually indexed to inflation. This means you can earn more taxable income before hitting the next-highest tax bracket.
  • Capital gain tax brackets will be adjusted for inflation, so that the federal brackets of 0% and 15% will allow more taxable gain within each before hitting the top bracket of 20%.
  • Tax breaks like the standard deduction will increase.

The Not-So-Good

  • Mortgage rates are higher than we’ve seen since 2008, and may go higher.
  • Social Security benefits are tax-free for those whose income does not exceed $32,000 for couples ($25,000 for individuals), and these thresholds have not risen in decades. When expenses go up and dollars buy less than they did last year, having more tax-free income can be significant. Social Security benefits themselves do increase with inflation.
  • The home sale exclusion of $250,000 for individuals and $500,000 for married filers has been static since 1997. In the expensive Bay Area, this usually means selling your home results in a big tax bill.
  • A stealth tax passed in the 2017 Tax Cuts and Jobs Act (TCJA) contained a provision to change the way parts of the tax code are inflation-indexed, namely pensions and other income tied to the Consumer Price Index for All Urban Consumers (CPI-U). Changing the inflation adjustment benchmark to Chained CPI-U from regular CPI-U was expected to raise federal revenue by $134 billion over 10 years by reducing inflation adjustments. These inflation adjustments affect pensions and worker income. The Kiplinger Tax Letter forecast that the Chained CPI-U will rise about 8.2% for the period October 2021 through September 2022, versus the forecasted increase of approximately 9% for the regular CPI-U. This 1% difference may feel like a big hit to many retirees and hourly workers.

Over the long term, returns from a diversified portfolio of stocks have been greater than inflation.

If you have concerns about inflation as it relates to your portfolio or your spending, please get in touch.