The January Consumer Price Index data registered an annual inflation increase of 7.5%, the highest level in 40 years. Labor and supply shortages with high consumer demand pushed up the number. So, when Mr. Market heard the words inflation coupled with Jerome Powell’s willingness to raise rates several times this year, starting in March, he had a frenzy. We’ll share the three areas where inflation and climbing interest rates may affect you.

 

1. Savings 

Every time you go to the grocery store, fill up gas or check your electricity bill, it’s clear that inflation is having an impact on your costs. Even though you may have a bump in salary, a bonus payout this month, or an increase in revenue from your business, it might not be enough to cover the jump in expenses. Your purchasing power could be dropping. But so far, consumers have been willing to pay the premium as their pockets have become cash-rich since the beginning of the pandemic (lockdown and not spending). But how long will this last?

It would be more accurate if your paystub indicated your real wage:

Nominal wage (take-home pay) – inflation = Real wage

In theory, earnings should keep pace with inflation, but they don’t. In December, the Social Security Administration raised its cost-of-living adjustment by 5.9%, the largest increase the organization has made in nearly 40 years. In our planning analysis for clients, we analyze the impact of different inflation scenarios on their lifestyles and their money outliving them.

2. Investments

Inflation affects different investments in different ways.

Assets that have a cash flow tend not to perform well as the purchasing power of those future cash flows decline over time.

From a high level, if your portfolio (all the assets you own) is heavily weighted to fixed income, then inflation may be an issue. If you’re 80% equities and 20% fixed income, then it’s less of a worry for you.

Stocks – U.S. stocks generally hold up well in inflationary periods. However, the type of stock you own could make all the difference. Do you own stocks that are sensitive to interest rates? Companies with a lot of debt on their balance sheets would be sensitive to interest rate changes. Large cap stocks may have a dampened effect because they have large market capitalizations compared to the debt due. Alternatively, they can retire some of that debt if needed. On the other hand, small cap stocks may have more debt as they tend to raise capital in order to operate.

Bonds – rising interest rates cause bond prices to fall. Since the rate of interest on fixed-income investments, as the name implies, is the same until maturity, the purchasing power of the interest payments declines as inflation rises. Longer-term bonds with a longer timeline of cashflows are impacted even more. It’s important to note that the Federal Reserve controls the short end of the yield curve. If you just focus on what the Fed does to navigate fixed income waters, it’s not a sustainable solution. There are lots of different rates that affect your portfolio.

Commodities – historically, commodities have had a strong relationship to inflation. Energy-related commodities like oil have a particularly strong relationship. Commodities also tend not to be correlated with the stock market, adding diversification benefits to portfolios. But commodity investments can be volatile, and market timing skills are required to take advantage of its inflation-hedging characteristics.

3. Taxes 

Federal taxes

There are different inflation adjustments for different tax provisions. As with most things in life, the financial impact will not be the same for all households, and it’s not just hitting wealthy households. Some will feel the pinch more than others.

There were some inflation adjustments made this year. The IRS increased the federal income tax brackets for 2022, standard deductions, and 401(k) plan limits.

However, some provisions didn’t change. For example, when a couple sells their primary home, they may exclude up to $500,000 ($250,000 if single) of profit from capital gains taxes, as long as they meet some requirements. Despite property values outpacing wages in the past decade, these amounts have not changed. Taxes on social security benefits have also remained the same for decades. The state and local taxes (SALT) cap hasn’t budged from $10,000.

State Taxes

Thirteen states, including New York and New Jersey, have income tax brackets that are not inflation-indexed. Let’s assume a New York resident had an increase in taxable income from $80,000 in 2021 to $85,000 in 2022. Due to inflation, her real income has the same or slightly less purchasing power than in 2021. But her state’s income tax brackets are not inflation adjusted, so her top marginal rate has increased from 5.97% to 6.33%. Her tax bill increased by $275 even though her purchasing power remained the same.

Conclusion

Forecasting inflation in 2022 has become more art than science, and there are so many factors to consider. When thinking about inflation, be clear on your goals. Are you trying to outpace it or hedge it? By combining the right mix of growth and risk management investments, you may be able to reduce the effects of inflation on your portfolio. Bear in mind that there are so many factors that go into designing your portfolio for the future, such as your unique goals and needs, tax implications, and withdrawal plans.

Give us a call if you want to learn more.

Adviso Wealth is dedicated to working with people just like you. We want to give you the clarity and confidence you need to achieve your personal and financial goals.

To learn more, visit advisowealth.com or email sweta@demo.advisowealth.com