The Federal Reserve Just Indicated Social Security Could Get a Bigger 2025 Cost-of-Living Adjustment (COLA) Than Expected | The Motley Fool

The Federal Reserve may have just given retirees the biggest indication yet that their 2025 cost-of-living adjustment (COLA) may be quite substantial.

The Fed is tasked with a dual mandate: to maximize employment while maintaining stable prices. Over the past three years, it's been in a battle with ongoing inflation. Its biggest goal right now is to push inflation below 2%.

The Federal Open Market Committee (FOMC) recently met and released a statement on May 1. At the top of the statement, the FOMC said, "In recent months, there has been a lack of further progress toward the Committee's 2 percent inflation objective." In other words, inflation just isn't coming down as quickly as hoped.

So, what does all this have to do with retirees' Social Security COLA?

The way the Social Security Administration determines the COLA each year is by using the average inflation rate in the third quarter, as determined by the consumer price index. If, as the Fed indicates, there's a lack of meaningful progress toward the committee's 2%-inflation goal, retirees could be in store for a bigger cost-of-living adjustment than anticipated.

That's not necessarily a good thing for seniors, though.

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Will inflation start coming down?

The Consumer Price Index (CPI) reading for March came in at 3.5%. Core inflation, which removes the volatile costs of food and energy, climbed 3.8%. Importantly, those numbers are above the 3.2% cost-of-living adjustment retirees received at the start of this year.

Not only is inflation failing to progress toward the FOMC's goal, but it's also trending upward.

There are still two months before the CPI readings start to count toward the COLA. A lot could change this spring, but the FOMC isn't nearly as optimistic as it was last fall when it indicated it could lower rates up to three times this year as inflation eases. Now, there's no indication when interest rates will come down.

At a press conference following the release of the FOMC's statement, Chairman Jerome Powell said, "So far this year, the data have not given us that greater confidence" that inflation is falling. He added, "It is likely that gaining such greater confidence will take longer than previously expected."

The good news is he doesn't think things are getting worse. He doesn't expect the Fed's next move to be an interest-rate increase.

Still, we'll probably reach the third quarter with higher inflation rates than what many anticipated at the start of the year, and that means a higher COLA for retirees. The Senior Citizens League already raised its COLA forecast from 1.75% to 2.6% last month. It might have to make another adjustment in the near future.

Why a bigger COLA isn't necessarily best for retirees

While an increase to your monthly benefit might sound great, the truth is an extra-large pay bump is usually a bad thing for retirees. There are a couple of reasons why.

First of all, the COLA is calculated based on a specific CPI reading called the CPI-W, or the Consumer Price Index for Urban Wage Earners and Clerical Workers. But what a young professional spends money on is drastically different from what a retiree spends money on. The latter is better represented by a CPI reading known as the CPI-E, the Consumer Price Index for Americans 62 and older, which looks at the basket of goods the typical senior spends money on.

The result of the discrepancy between the COLA, based on CPI-W, and rising CPI-E generally means a senior's expenses rise faster than the COLA. And that's been true so far this year as CPI-E has increased more than the CPI-W in each of the first three months of the year.

The second thing retirees need to consider is taxes. While their Social Security income might increase, the income limits before that money becomes taxable do not. They haven't changed since the 1990s as no inflation adjustment was baked into the law. Since those thresholds remain low, a large number of retirees will pay more in taxes as a percentage of their income with a bigger benefit. As a result, the purchasing power of a retiree's Social Security checks is reduced even further, mitigating the upside of their COLA.

A lot can change over the next few months, but there's little indication that inflation is coming down soon. That may mean a bigger COLA, but it also probably means less purchasing power for retirees.