An Economic Red Flag Is Flashing -- and It Points to a Higher 2027 Social Security COLA

Doom and gloom have been the prevalent mindset among Americans several times during the past. Consumer sentiment fell sharply in the late 1970s as the economy experienced stagflation. It was understandably low during the financial crisis of 2007 through 2009. Consumers also worried during the early days of the COVID-19 pandemic.

However, the University of Michigan's latest consumer sentiment index reached an all-time low, worse than during the financial crisis that triggered the Great Recession or the initial days of the pandemic. An economic red flag is clearly flashing -- and it points to a higher 2027 Social Security cost-of-living adjustment (COLA) than many expect.

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Declining consumer sentiment, rising inflation

Why is consumer sentiment at an all-time low when the U.S. economy isn't in recession? The one-word answer is inflation.

Prices soared in the aftermath of the COVID-19 pandemic shutdowns. While inflation eventually waned, President Trump's tariffs implemented last year created new inflationary pressures. The war with Iran, though, is the primary culprit now. Iran's disruption of traffic through the Strait of Hormuz has sent oil and gas prices soaring. Consumers can't help but feel the pain in their pocketbooks after filling up their cars and trucks with gasoline.

The University of Michigan's Surveys of Consumers Director Joanne Hsu stated in her comments on the latest consumer sentiment report, "Critically, consumers appear worried that inflation will increase and proliferate beyond fuel prices, even in the long run." Those fears could be justified.

Higher oil prices will likely lead to higher product prices for a simple reason: transportation costs make up a significant share of the overall cost of many products. The prices of petroleum-based products, such as plastics, could rise more than those of other products.

Piper Sandler (NYSE: PIPR) analysts predict that the Strait of Hormuz will remain "largely closed for months", leading to even higher oil prices. Even if that view is overly pessimistic, some energy analysts think oil prices will remain elevated for years due to low investment in new oil supply.

Rising inflation, higher COLA

How does the 2027 Social Security COLA fit into this discussion? If inflation continues to rise, next year's Social Security benefit increase will be higher than anticipated.

The latest estimate from The Senior Citizens League (TSCL), a nonprofit organization that advocates for seniors, is that the 2027 COLA will be 3.9%. This would be the highest increase since 2022 and the third-highest increase in the last 15 years.

However, the actual 2027 Social Security COLA will be based on inflation, as measured by the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), in the third quarter of the year. Should oil prices remain elevated and push up the costs of other products, the CPI-W a few months from now will almost certainly be higher than it is now.

Indeed, if American consumers are right, inflation will be significantly higher later this year. The University of Michigan's survey found that consumer inflation expectations over the year ahead are now at 4.8%.

Good news, bad news

The good news for retirees is that a higher Social Security COLA will help offset higher product prices. The bad news is that, whatever the Social Security benefit increase is next year, it probably won't be enough.

TSCL Executive Director Shannon Benton said in a press release, "For retirees living on fixed incomes, the costs that matter most, especially healthcare, housing, utilities, and insurance, continue to rise faster than prices in the rest of the economy, silently wrenching seniors dry." She raised a good point.

Unfortunately, the CPI-W inflation metric used by the Social Security Administration to calculate the annual COLA isn't designed to reflect the costs seniors incur. In particular, it underweights healthcare costs in retirement.

If consumers are right, the 2027 COLA could be well above the current estimate of 3.9%. But retirees may find that their "raise" is only an illusion.

Keith Speights has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.