How Inflation Affects Your Cost of Living

By Michelle Ullman | August 15, 2014 AAA
How Inflation Affects Your Cost of Living

If you think your dollars aren’t stretching as far at the grocery store, you’re not imagining things. The U.S. Department of Agriculture expects food prices to rise 2.5% to 3.5% over 2013's prices, with several categories, including beef, fruit, dairy and eggs hit even harder. And it’s no different at the gas station, where prices at the pump hit an average of $3.70 in June 2014 – 13 cents higher than gas prices at the same time a year ago.

You might hear a lot about rising inflation and cost of living, but what do these terms really mean? And most important, how do they affect your daily life?

What’s the Difference Between Inflation and Cost of Living?

People often use the phrases “cost of living” and “inflation” as if they were synonymous. They are not the same, although 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 Consumer Price Index (CPI) – a monthly measure by the Bureau of Labor Statistics that averages the cost of a representative basket of goods and services from areas around the country. It then reports the result as a percentage rise or fall.

Cost of living, on the other hand, is a more focused picture. This number averages the cost of an accepted standard of living that includes food, housing, transportation, taxes and healthcare. Cost of living is frequently used to compare life in different locations around the country or the world. For example, if you made $50,000 per year living in New York City, you could maintain the same standard of living in Chapel Hill, NC on half that annual salary – the cost of living in New York City is twice as high as in Chapel Hill.

When the Going Gets Expensive

It’s easy for most people to feel the effects of cost-of-living increases in their daily life. But rising prices hit the lower and middle classes especially hard. Higher food, gasoline and utility costs mean less money remains once these necessities are paid for, leaving little for savings or discretionary spending. To compensate for the rise in prices, consumers tend to buy less, switch to less-expensive substitutes or drive farther to find bargains.

It’s especially difficult to keep up with the rising cost of living when your paycheck isn’t growing at a similar rate. According to the Bureau of Labor Statistics, the median weekly earnings for full-time wage earners was $780 in the first quarter of 2014 – unchanged since last year, although the CPI has risen 2.1% since then.

How Inflation Hits the Housing Market

You would assume that higher inflation means higher prices for real estate, and that is 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 other financial institutions using the Federal Reserve Bank. 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 tend to drop their asking price to attract buyers. Although economic recovery is far more complicated than any single factor, lower interest rates have helped the devastated housing market begin its slow recovery since 2008. 

The Bottom Line

With pay increases lagging behind rising inflation, you can expect your wallet to continue to take a beating as the cost of living increases in just about every aspect of daily life. But try to keep your eye on the long term. Although you may need to cut back spending in some areas, don’t let today’s high prices discourage you from saving for tomorrow’s needs.

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