How Inflation Affects Your Cost Of Living (2024)

Until recently, inflation was a far-off memory for most Americans. But that faded, distant memory has roared back to life over the past two years, imposing higher costs and painful choices on consumers.

After spending more than two decades below 3%, the consumer price index (CPI)—a key measure of U.S. inflation—nearly tripled from 2020 to 2021, rising from 1.4% to 7.0%. Inflation fell a bit, to 6.5%, in 2022.

Why Is Inflation Rising Right Now?

The U.S. hasn’t seen price gains like this since the era of hyperinflation in the 1970s and early 1980s. Monthly inflation data peaked at an annualized rate of 9.1% in June 2022, and it’s cooled off somewhat since then.

“The high inflation we’re experiencing today is likely brought on by a combination of factors including a strong post-Covid recovery, lingering supply chain issues, the war in Ukraine and its effects on energy and food prices, Fed rate hikes and gains in wages after years of low growth,” says Matt Fleming, a wealth advisor executive at Vanguard Personal Advisor Services.

Meanwhile, stimulus checks and the suspension of student loan payments during the pandemic gave Americans an unexpected opportunity to save money, says Michelle Griffith, wealth advisor for U.S. Consumer Wealth Management at Citi.

“But after social distancing and the shelter-in-place mandate came to an end, spending started up again, and inflation reared its head,” says Griffith.

While Fleming says inflation has peaked in most markets and should keep trending lower, he believes it will take much longer to dispel the pressures that created higher prices in the first place—things like historically low unemployment and higher wage growth.

What Causes Inflation?

Inflation occurs when changes throughout the economy drive prices broadly higher, reducing consumer purchasing power. This means that each dollar you earn buys fewer goods and services.

The root cause of these broad-based price increases are imbalances in supply and demand. There are three primary reasons demand may outpace supply: supply shocks, increased money supply and consumer expectations.

During the Covid-19 crisis, consumers were kept at home by shelter-in-place orders and thus less inclined to spend money on discretionary activities, but spent more money on buying goods.

The world experienced severe supply shocks during the pandemic, making it hard for supply to keep up with demand. Luckily, spending for much of the pandemic was reduced as people were forced to stay home, giving Americans an unexpected opportunity to save.

According to Griffith, when consumers start saving up cash, it can eventually lead to enthusiastic spending sprees, which can drive higher prices and more inflation. And that’s exactly what happened when stay-at-home orders were dropped and people could resume social activities.

Another cause of excess demand that leads to rising prices are inflation expectations. If workers expect inflation to rise, they may demand higher wages to compensate, which may prompt businesses to raise prices in turn, thus creating a “wage-price” spiral.

Inflation vs Cost of Living: What’s the Difference?

Inflation and cost of living are interconnected concepts, but they are not synonyms. Inflation describes a gradual increase in prices, while the cost of living is a snapshot of how much a person needs to spend at any given moment in time.

“When inflation rises, so do the costs of goods and services, which, in turn, erodes purchasing power,” Fleming says. “This is particularly troublesome for those with lower fixed incomes, as inflation can rob their ability to afford necessities like food, housing, medications and transportation.”

To compensate for inflation’s erosion of purchasing power, retirement benefits providers may offer cost-of-living adjustments (COLAs).

• Inflation. This is how much prices for goods and services increase over time. The Bureau of Labor Statistics (BLS) uses the CPI to track the rate of inflation. There are CPIs for the entire U.S. as well as specific geographic areas and utility, gas and food items. Changes are reported on a monthly basis as percentage increases or decreases in the CPI.
• Cost of living. This is how much it costs to maintain a certain standard of living in a given place at a certain moment in time. It’s usually calculated by averaging the costs of specific goods and services required to meet that standard of living. The government uses regional and national CPIs to determine the cost of living in specific areas.
• Cost-of-living adjustments. COLAs are adjustments to specific benefit payments, such as Social Security, to keep pace with inflation. Without COLAs, retirees would still be receiving only $157.70 in monthly Social Security benefits, as they did in 1975. This would be unfair since $157.70 could buy a lot more in 1975 when gas cost $0.57 per gallon.

Inflation Factors that Affect the Cost of Living

Inflation can impact the price of everything you need for daily living, from food to housing to what it costs to fill your tank so you can drive to work or put clothes on your back.

For example, here’s how the prices of common household items increased in December 2022 from the same period one year ago:

How Is Inflation Affecting the Housing Market?

Inflation can have a similar effect on the housing market as it does your cost of living. Shelter accounts for nearly one-third of the inputs for CPI inflation and 40% of core CPI that excludes food and energy, so even small increases in rents and home prices can impact inflation.

“The housing market has been impacted by inflationary pressures on multiple levels including higher material and labor costs combined with rising interest rates and mortgage expenses, which have weighed on affordability,” says Sid Vaidya, chief investment strategist for U.S. Wealth at TD Wealth.

Rising rates have priced some buyers out of the market, but he says there’s still reason for hope.

“While inflation continues to linger at elevated levels across most advanced economies, recent data has provided some initial signs of relief from improving supply chain conditions and softening raw input prices,” Vaidya says.

No one can predict with certainty how high inflation will rise or when it will end. The one thing most experts agree on is that planning ahead is crucial.

Having an emergency fund can give you the cushion and confidence to keep your longer-term savings fully invested, which is crucial to keeping pace with inflation.

“Stay focused on your goals and enjoy the long-term benefits of a diversified portfolio,” Fleming says. “Transition periods can be painful in the moment, but instead of focusing on recent losses, focus on the gains you’ve likely seen in your portfolio over the past decade.”