How Inflation Affects Your Cost of Living

Up until very recently, inflation wasn’t talked about much, and for good reason. In 2019, the overall annual rate of inflation in the U.S. was running at 1.8% according to the World Bank (CPI). In 2020, the rate was 1.2%.

In the summer of 2021, however, inflation began to rear its ugly head once again, with U.S. consumer prices recording their largest annualized increases in more than 13 years. From there, inflation continued to surge. Overall inflation in 2021 was 4.7% and it reached a peak of 9.1% in June 2022.

Since then, the inflation rate has gradually come down but it still remains high. For the 12 months that ended in September 2023, the annualized inflation rate in the U.S. stood at 3.7%, and as of October 2024, the inflation rate stands at 2.4%.

Still, we’ve been through worse inflationary times. There’s talk about inflation and cost of living increases, but what do these terms really mean? And most important, how do they affect your daily life?

Key Takeaways

Inflation measures the increase in the price of goods and services. Or, the decrease in the buying power of the dollar.
Cost of living measures the change in price, up or down, of the basic necessities of life like food, housing, and healthcare.
Housing prices are affected by many factors but one of the biggest is the cost of borrowing.

Investopedia / Ellen Lindner

The Difference Between Inflation and Cost of Living

People often use the phrases inflation and cost of living as if they were synonymous. However, they are not, although they’re closely related.

Inflation is the big picture. As the cost of goods and services rises, the buying power of the dollar falls. The inflation rate is often measured by the change in the Consumer Price Index (CPI), a monthly measure by the Bureau of Labor Statistics (BLS) that averages the cost of a standard basket of goods and services from areas around the country. It reports the result as a percentage rise or drop in CPI.
Cost of living has a different focus. This number represents the average cost of an accepted standard of living including food, housing, transportation, taxes, and healthcare. The figure for the cost of living is frequently used to compare the minimum income needed to live in various locations. According to Payscale’s calculator, as of Oct. 14, 2023, the cost of living in New York City is 128% higher than the national average. As a comparison, the cost of living in Chapel Hill, North Carolina is 2% higher than the national average.

Cost of living is a far more difficult number to pin down than inflation. It varies widely not only by region but by demographic group. Whether your own cost of living goes up or down depends on how you live and where you live.

The amount that Social Security recipients receive is adjusted annually based on the cost of living. The increase for 2023 was 8.7%. The increase for 2024 is 3.2%.

When the Going Gets Expensive

Most people feel the effects of cost-of-living increases in their daily lives. But rising prices hit the middle class hard, and the lower-paid even harder.

Higher food, gasoline, and utility costs mean less money for savings and less for discretionary spending. To compensate, consumers buy less, switch to cheaper substitutes, look harder for bargains, or put off major purchases.

2.4%

The current inflation rate in the U.S. for October 2024.

The Paycheck Factor

An increase in the cost of living is irrelevant only if your paycheck is growing at a similar rate. After a painful lag, the paychecks of full-time workers appear to be catching up with the rate of inflation, and even surpassing it a bit.

According to the Bureau of Labor Statistics, the median weekly earnings for full-time wage earners was $1,165 in the third quarter of 2024. That’s an increase of 4.2% from a year earlier compared to the 2.6% increase in the Consumer Price Index for All Urban Consumers (CPI-U) for the same period.

How Inflation Affects the Housing Market

Although the assumption is that higher inflation means higher prices for real estate, and that might often the case, at least at the start of a significant spike in inflation, but then things can get complicated.

To keep inflation rates under control, the Federal Open Market Committee (FOMC) often steps in and raises the federal funds rate, which is the interest rate charged to banks that use the Federal Reserve Bank as a source of short-term loans. This has a domino effect on every other loan rate, including the rates for home mortgages.

As the cost of home loans goes up, many consumers are squeezed out of the market, leading to a slowdown in home sales. With homes on the market for longer periods, sellers drop their asking price to attract buyers.

Lower interest rates helped the U.S. housing market make its recovery after the gut punch of the 2007-2008 financial crisis, and then again during the COVID-19 pandemic. Higher interest rates have the opposite effect, reducing demand for loans in order to cool down inflation.

What Is the Relationship Between Inflation and the Cost of Living?

Inflation is the increase in the average price of a basket of goods. It reduces the purchasing power of consumers, meaning that a unit of currency buys less than it did before inflation.

The cost of living measures the average cost of the accepted standard of living in a specific area.

Inflation increases the cost of living.

What Are the 3 Causes of Inflation?

The three causes of inflation are demand-pull (when the demand for goods and services is greater than the supply, putting upward pressure on prices), cost-push (when the total supply of goods and services that can be produced falls), and built-in inflation, also known as inflation expectations.

That last factor is the pressure on wages that is created when workers believe that inflation will continue and demand higher wages to maintain their cost of living. Higher wages mean higher costs, which are passed onto consumers as price increases.

Why Has Inflation Been Slowing?

In 2024, inflation slowed while not disappearing altogether. The most obvious reason is a series of interest rate increases imposed by the Federal Reserve as a deliberate tactic to defeat inflation.

However, that is not the only reason. Another big factor is the normalization of the global economy after the disruption caused by the COVID-19 pandemic. Supply chain disruptions caused delivery delays and shortages around the world. Production shutdowns and labor shortages added to the disruption. Costs rose from 2021 to 2023.

The Bottom Line

Inflation and cost of living are related metrics but not identical. While inflation measures the average increase in prices of a basket of goods, the cost of living looks at the expense of a certain standard of living, which can change by location.

Increases in inflation increase the overall cost of living and if wages are not increasing to match the increase in the cost of goods and services, the value of a consumer’s dollar will decrease.

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