Fed's 2% Inflation Target: A Hidden Tax on Retirees and Homeowners

The Federal Reserve has set its long-term inflation target at 2% since 2012. According to the St. Louis Fed website, this target is meant to allow the economy to run efficiently with low and stable inflation, giving people peace of mind that their money's purchasing power won't be eroded by high inflation.

However, a couple who retire at age 65 with a $1 million portfolio invested in long-term bonds yielding 5% may see their real purchasing power reduced by 45% to $27,500 in 30 years if they spend the $50,000 in interest each year and there is 2% inflation.

Most retirees estimate an initial amount to spend from their portfolio that can grow 2% annually without bankrupting them before turning 95: $30,000. But this is misleading because with no long-term expected inflation, they should expect to earn 2% less on their portfolio, reducing the annual interest to $30,000.

But even this reduced income is taxed on the 'phantom' income caused by inflation, which can lead to substantial losses of spendable income. For example, with a California tax rate and Social Security income, they could lose about 12% of their spendable income from their portfolio, or around $2,400 if they have a Vanguard asset allocation.

The insidious impact of the 2% target also affects homeowners, who may not be able to afford mortgage payments or down payments. If mortgage rates were substantially lower due to a reduced inflation target, up to 9 million households could buy their first home, and millions more might have avoided the costs of selling their first home and moving to a new one.