ECONversations: The Inflation Experience: A Conversation about the Cost of Living - September 23, 2015

What is the cost of living, and how does it relate to inflation? Although the two terms are often used interchangeably, they are not the same thing, explained Atlanta Fed economist Brent Meyer during an ECONversations webcast on September 23.

The cost of living describes how difficult it is to buy a certain level of well-being. "It's a real concept that would occur even in a world without money," Meyer said.

An increase in food prices due to drought or some other supply shock, for example, can raise the cost of living. Absent an increase in the quantity of money, households would have to spend less elsewhere—on entertainment, for example—to account for higher food prices.

Inflation, on the other hand, is what happens when too many dollars are chasing too few goods, Meyer explained. The result is an erosion in the purchasing power of our money. In other words, a dollar, over time, buys less than it did before. In the United States, the Fed controls the money supply and is thus responsible for controlling the rate of inflation.

Uncovering the inflation trend in price increases
Distinguishing how much of a price increase is due to inflation and how much is due to a supply shortage or some other market force is no easy task. Economists often look for signals embedded in the Consumer Price Index (CPI) to gauge the rate of inflation.

One such measure, the Sticky-Price CPI, includes only items for which price changes tend to occur relatively infrequently. "Sticky" prices appear to be largely immune to near-term changes in business conditions and are usually better predictors of future price behavior, Meyer noted. "We think there's an embedded inflation expectation component in this measure that helps us uncover the underlying inflation trend," he explained.

Different people, different costs of living
The CPI reflects the prices paid by the average urban household for a fixed basket of goods and services. But what if your spending habits aren't average? For example, "infant and toddler apparel" accounts for about 0.17 percent of the average market basket, but this is unlikely the case for households with no children, Meyer noted. Likewise, "gardening and lawn care services" probably accounted for a less-than-average share of apartment dwellers' expenditures.

How individuals experience changes in the cost of living, as measured by the CPI, varies across a range of demographic characteristic including age, income, homeownership status, education level, and household size.

The Atlanta Fed's new web tool, myCPI, takes these differences into account. "myCPI more closely captures the uniqueness of individuals' market baskets," Meyer said. "One of the 144 different market baskets could yield a closer approximation to your cost of living than one based on the average consumer," he explained.

ECONversations is an Atlanta Fed economic webcast sharing high-level updates on economic and policy issues, and offer the public the opportunity to ask questions of Fed experts.