Have you recently felt like you spend much more on day-to-day items than a year ago? You might be right even if your spending habits did not change at all. As of February 2022, the inflation rate in the United States has reached the highest level in the last 40 years of 7.9%. Even though 7.9% may not look like a lot, the long-term target inflation rate set by the Federal Reserve is only 2%. Moreover, inflation has hit different items differently. For example, the prices of used cars have increased by more than 40% in the last year while apparel prices have increased by less than 7% in the same period. There are many reasons why inflation is high right now, but the question is how does inflation even relate to the cost of living?
Inflation and the cost of living are two sides of the same coin. The inflation rate is a measure of the change in the Consumer Price Index, which is also known as CPI. This index tracks the price of a weighted basket of goods and services. This basket includes the prices of many different items such as food, energy, commodities used by a consumer, health care services, etc. Generally, when the prices rise, the CPI increases, which leads to a positive inflation rate. This means that a positive inflation rate directly relates to the increase in prices of various goods and services used by consumers.
The cost of living measures how much money a consumer needs to sustain their lifestyle in a certain area. If the prices rise, the cost of living rises too. Since the change in prices directly relates to the inflation rate and the cost of living, the inflation rate directly relates to the cost of living. The higher the inflation rate, the higher the cost of living.
The difference between the two is that the inflation rate is a general metric that is used in a discussion of purchasing power of a US dollar. There are many financial tools available online, and they allow you to see how the purchasing power of a US dollar changes over time due to inflation. These tools include an inflation calculator that can provide an insight into how inflation deteriorates the value of money over time. For example, you need to earn $3,531 today to buy the same amount of products as $100 could buy in 1900. This means that the total inflation rate over that period has reached around 3,531%. The inflation rate is a generic measure that does not apply to a single product. Even though the inflation over the specified period was 3,531%, it is unlikely that the prices of a house, transportation, and childcare have all increased by exactly 3,531%. Instead, it provides an insight into the average price increase of many different goods and services.
The cost of living increases with inflation, but it is not used to talk about the purchasing power of a dollar as often. Instead, the tools that revolve around the cost of living try to compare how much cheaper or more expensive it costs to live in one area compared to another. Even though the inflation rate is reported for the United States, different regions may experience different increases in prices. For example, the middle states require transportation of goods from the ports located in the coastal states. This means certain products have to incur additional costs to be transported to the regions. If the region is hard to access, the prices for the transported goods may be much higher than in the states where they are manufactured because of the extra transportation cost. On the other hand, the areas with a robust job market may experience higher prices for services than other regions because of the difference in wages.
A cost of living can be a useful metric when you are planning to move to another area. A cost of living calculator is a tool that can provide an insight into what you should expect to pay to sustain your current lifestyle. For example, if you are single and are planning to move from New York to San Francisco, you should expect to spend 20% extra to sustain your current lifestyle. The cost of living in San Francisco is higher because it has higher housing costs and food costs. On the other hand, San Francisco has a lower transportation cost compared to New York. This means that even though some costs may be increasing the cost of living, other costs may be counteracting this increase. It is important to note that the calculations may be much more complex for households with kids because it has to account for the cost of raising children, which may be quite expensive.
Both of the metrics are useful in a specific context. If your goal is to track how much money you have to spend in the future for the same products you buy today, you should consider looking at the inflation rate. The inflation rate will be able to provide an insight into how the purchasing power of a dollar changes over time. Of course, the inflation rate will not tell you exactly how much you will have to spend later on to sustain your lifestyle because it is a generic metric. Depending on your spending habits, you may experience a higher or lower increase in the cost of living. If you are not worried about future costs but rather want to compare how much you may have to spend in another area to sustain your current lifestyle, you should look at the cost of living in the areas of your choice. There is an abundance of information on prices in different areas available online, so it might be easier to calculate precisely how much you will have to spend if you chose to move to another region.
Regardless of what metric you look at, both of them can be useful to manage your money wisely. Expenses are not the only thing you need to consider because income plays an important role in managing your money too. Income tends to increase with inflation, so if you have a high income relative to your expenses, you may not need to worry about inflation and simply make sure that your expenses are not increasing faster than your income.