Inflation has not been talked about much lately, and for good reason. In late 2019, the overall annual rate of inflation was running at about 1.8%. The U.S. Department of Agriculture reported that it expected retail food prices to come in at an increase of 0.5% to 1.5% for the year as a whole. The forecast for 2020 was the same.

Keep in mind, these numbers are historically low, and 2020 will be the fifth consecutive year of lower than average or even deflationary prices for food.

We've been through worse times. Still, there's always 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?

The Difference Between Inflation and Cost of Living

People often use the phrases inflation and cost of living as if they were synonymous. They are not the same, 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 that averages the cost of a 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. Cost of living is frequently used to compare minimum income needs in various locations. If life in New York City costs $100,000 a year, life in Chapel Hill, North Carolina costs $42,000, or 58% less, according to PayScale's calculator.

Cost of living is a far more difficult number to pin down, and it varies widely among different demographic groups as well as different regions. In 2019, the Social Security Administration raised benefits by 2.8% as a cost of living adjustment. Whether your own cost of living went up or down in 2019 depends on how you live and where you live.

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 harder.

1.8%

The overall annual U.S. inflation rate as of November 2019.

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

The Paycheck Factor

It’s especially difficult to keep up with the rising cost of living when your paycheck isn’t growing at a similar rate. And this is where the good news comes in.

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, 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 of them is the cost of borrowing.

According to the Bureau of Labor Statistics, the median weekly earnings for full-time wage earners was $919 in the third quarter of 2019. That's a gain of 3.6% from a year earlier.

It also more than offsets that overall inflation rate of 1.8%.

How Inflation Affects 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. 

Lower interest rates helped the U.S. housing market make its recovery after the gut-punch of the 2008-2009 financial crisis.