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%.

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?

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, 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.

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. 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.

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 $1,118 in the third quarter of 2023. That's an increase of 4.5% from a year earlier compared to the 3.5% increase in the Consumer Price Index for All Urban Consumers (CPI-U) for the same period.

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 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.

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, 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.