Inflation and the actual cost of living

The misery index, the sum of unemployment and inflation, may understate misery because the cost of living to households and the affordability of key products are affected by myriad factors in addition to the rate of inflation.


Many analysts confound the concept of inflation and the cost of living.  Inflation is the change in the average price of goods and services in a basket of goods.   The cost of living is the total amount of money needed to meet basic expenses. 

The cost of living will increase with inflation, but this relationship is impacted by the way inflation is measured and other factors specifically loans and interest rates.

Economic or political arguments based on current and projected inflation numbers, which ignore other factors impacting the cost of living, often lead to specious conclusions. 

Often advocates of a particular policy argue that aggregate price indices either over or under state inflation to support their policy position.

  • An economist in a recent CNBC argued that the Federal Reserve Board should cut interest rates because the housing shelter cost component of the CPI provided a misleading estimate of housing cost increases.  (Saw on TV, sorry can’t find link.) 
  • Several economists, most notably the Boskin commission, argue a failure to adjust product prices for quality improvements has led to an overstatement of the CPI and inflation. 
  • Some politicians and economists have called for linking Social Security benefits to an alternative price index, which has a higher weight on health services.

Another major difference between inflation and the cost of living is that the later concept is substantially impacted by lending, loan terms, and interest rates while the former concept is exclusively based on prices of goods and services. 

This memo discusses the impact of different measures of inflation, cost of living and affordability on the current economic situation.

Analysis of components of the Consumer Price Index:

The measurement of three components of the CPI – shelter, health insurance, and advanced goods like computers – does not reflect the impact on affordability of these goods for many households.   


The cost of shelter in the consumer price index, the single largest component (around one third of the basked of goods) is determined by  actual and imputed rents.

The use of imputed and actual rents to measure shelter costs makes more sense than the use of house prices because volatile asset prices increase wealth and inflation can decrease real wealth.  Actual shelter costs as measured by rent and imputed rent are sticky and tend not to fall, hence actual and imputed rent does track annual changes in costs. 

However, housing affordability, especially for first-time home buyers has fallen.  The Goldman Sachs housing affordability index (based on three factors household income, housing prices and mortgage rates) reached a record low in October 2022.  Recent research has documented the link between housing prices and homelessness.   Moreover, unaffordable housing situations has led to an increase in the number of people retiring with mortgage debt.  

Housing affordability may be more closely related to financial stress associated with high house prices than the shelter component of the CPI.

Health insurance

The CPI uses an indirect measure of health insurance premium inflation.   The CPI health insurance premium cost estimate is the portion of insurance premiums not used for medical 

Medical services and goods have a separate index.  

Most private health insurance in the United States is obtained through employers.  Typically, both the employer and employee pay a portion of the health insurance premium with the employee share varying across firms and changing overtime.  

The CPI price inflation index measures the combined cost of the health insurance to the employer and the employee.  It does not measure the cost to the household which is impacted by the employee share of the health insurance premium, the deductible and coinsurance and copay rates.   By contrast, a cost-of-living statistic would directly measure the amount households spend on their own insurance premium.  Note that an increase in total premiums will increase household expenses even if the employer share of the health insurance remains constant. 

Health plans require insured households to share in the cost of health expenditures with the share being determined by the deductible and coinsurance rates and other terms in the plan.  These health plan features also change over time and vary across firms.  A report by the Kaiser Family foundation founds the average general deductible of covered workers rose by 13 percent over the past five years and 68 percent over ten years.  The CPI does not account for the increased share of premiums paid for by households. A cost-of-living statistic would account for this shift.

Deductibles are not the factor impact the cost of health insurance for households.  Co-insurance rates define the portion of health expenses paid for by the household.  The in-network and out-of-network health coinsurance rate will often vary, and some health plans do not allow out-of-network service.  Coinsurance rates also differ for different types of services. Copayments are often charged for lab or doctor visits. The CPI does not account for any of these factors, but all of these factors impact the cost of health care and the cost of living.

The enactment of the Affordable Care Act allowed people to use a tax credit that is linked to income to purchase health insurance on state exchanges.  The total premium is linked to age.  It is higher for older people than younger people.  Many middle-income and upper-income people pay more for their health insurance under state exchanges than under employer-based plans because many employer-based plans pay a substantial share of the health insurance.  (Middle-income young adults could typically pay 100 percent of state exchange health insurance and around 30 percent of the premium of employer-based plans.) 

The CPI does not capture the increase in costs stemming from a shift towards state exchange health insurance.  A weighted average cost of living index would measure the higher cost imposed on some households.

Computers and other advanced goods:

Several products in the basket of goods used to calculate the CPI are adjusted for changes in quality via a hedonic price index.   The adjusted price used in the calculation of the aggregate price index and underlying inflation is lower than the actual price because the new computer or cell phone or software is better than the old one.    The theory is that the improved product causes increased productivity and utility, hence the higher price of the new product is not reflective of inflation.

One problem with this argument is that quite often the old product is unavailable, and consumers have no choice but to spend the actual price on the new product.  A replacement purchase is mandatory if new software does not work on the old device.

Second changing social norms can make the purchase of a new product unavoidable.  A cell phone is now almost mandatory for most people in the workforce.  The improved quality of the cell phone does not obviate the fact that it is now an essential product.

Third, some improvements in quality prove illusory.  Hertz is cutting back on its purchase of electric vehicles partially because of higher than expected repair costs.  EVs also have limited range. 

Fourth, increases in prices due to quality improvements lead to higher insurance costs.  Even if insurance prices remain constant, an increase in the amount of insurance purchased due to the higher price of the vehicle will increase the cost of living. 

It may be appropriate to adjust the CPI for quality improvements, but quality improvements don’t always lead to lower living costs.

The impact of debt and lending terms on the cost of living:

The CPI and inflation measures do account for the increased use of debt and alterations in the terms of debt on the cost of living.  

The largest impact of debt on living costs pertains to the increased use of student loans.  Debt per student has risen from $18,230 in 2007 to $37,650 in 2023.  This increase in debt is larger than the rate of inflation.  (Figures adjusted for inflation are $26,720 in 2007 to $37,650 in 2023.). The increased use of student debt will result in an increased use of unsubsidized student debt, which leads to higher total repayments because interest because the federal government makes interest payment on student loans while the student is in school. 

The average maturity of car loans, which is now near 70 months, has increased over time.

The CPI and measures of inflation do not account for higher living costs induced by increased debt and changes in the terms of debt.

Concluding Thoughts:

The misery index, the sum of the unemployment and inflation rate, suggests the economy is moving in the correct direction.  However, official inflation rates understate misery because changes in average prices do not measure all factors impacting the cost of living.

Authors Note:  Recent posts by David Bernstein include, The Case Against Medicare AdvantageAn Interest Rate Forecast and Investment Advice, and Questions and Answers on IDR loans and the SAVE program.

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