Retirees are looking forward to next year's cost-of-living adjustment (COLA) for Social Security, and it's easy to see why.

Beneficiaries are set to get their biggest Social Security increase in 40 years, as checks for recipients are on track to rise 8.9% as of the latest inflation report. That additional income should go a long way to helping seniors handle additional costs for housing, food, transportation, and utilities, among others. 

However, the hike in Social Security payments could be problematic for the economy in other ways. That's because the COLA will pump billions of dollars in the economy at precisely the time when the Federal Reserve is trying to reduce liquidity and ramping up benchmark interest rates as fast as it has in nearly 30 years.

$100 bills and a treasury check on top of a social security card.

Image source: Getty Images.

A vicious cycle

According to conventional wisdom, a significant increase in the money supply during the pandemic contributed at least partially to today's high inflation as multiple rounds of economic stimulus injected capital into the economy in 2020 and 2021. A study by the San Francisco Federal Reserve Board found that fiscal stimulus accounted for three percentage points of inflation by the end of 2021, and prices have continued to rise since then. Other factors have played a role in inflation such a supply chain constraints, labor shortages, and the war in Ukraine.

The U.S. fiscal and monetary response to the COVID-19 was unprecedented in its scale. The government pumped $2.3 trillion into the economy in the first stimulus package, the CARES Act, and the five federal stimulus packages passed during the pandemic totaled roughly $5.6 trillion in government relief. . 

As a result, there was an enormous expansion in the U.S. money supply. As the chart below shows, the M2, one popular measure of the monetary supply, surged in the spring of 2020 when the pandemic hit and the CARES Act was passed. From 2020 to 2022, it jumped nearly 50% from the 2020 to 2022, adding almost $7 trillion to the economy.

US M2 Money Supply Chart

US M2 Money Supply data by YCharts

By contrast, the impact of next year's Social Security COLA should be less considerable. Since the average Social Security recipient got $1,657 a month this year, the estimated 8.9% increase coming next year would translate into an extra $147 a month, on average, for the 70.3 million Americans collecting Social Security. Compared to the COLAs of around 2% that have been more typical, that represents an additional $114 a month Social Security recipients will get. Over the course of the year, that equals an incremental $96.1 billion being injected into the economy. In total, the COLA will pump $124 billion into the economy.

That is likely to encourage more spending since retirees will have more money to put to use, making it harder for the Federal Reserve to bring inflation under control, but the impact will be minimal compared to the pandemic stimulus packages.

What it means for retirees

Many retirees are looking forward to next year's COLA, and while it won't be in the double-digit percentages as some prognosticators had forecast earlier, it will be the highest cost-of-living adjustment since 1981. The extra $147 a month will help millions of Social Security beneficiaries afford their prescription drugs, food, and other core expenses. 

But inflation remains a bogeyman for retirees. Though there are signs that price increases are moderating, core inflation, which doesn't include energy and food prices, remained elevated in August, meaning interest rates will likely have to go higher to cool off inflation. 

Since each January's Social Security COLA is based on data from the third quarter of the prior year, those cost-of-living increases lag behind real-time inflation by as much as 15 months. If inflation remains high next year, the 2023 COLA won't be enough to cover those price increases. 

If you're a senior, the ideal scenario at this point would be inflation cooling off rapidly without the economy falling into a recession. The good news is that the 2023 COLA's broader impact on inflation should be negligible, especially in light of the Federal Reserve's efforts to rein it through interest rate hikes and quantitative tightening.