September 29, 2022 11:08 pm
September 29, 2022 11:08 pm

How Current US Inflation Affects Low Income Earners More

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There is some debate over whether inflation impacts high income or low income earners more. On the one hand, people with high incomes are more likely to have savings. With high yield savings account rates barely over 1% and inflation running over 8%, any cash in a high yield savings account loses purchasing power over time. On the other hand, low income earners are less able to substitute current spending for less expensive alternatives as they are likely using less expensive options already. In this post I’ll argue why current US inflation affects low income earners more than high income earners.

CPI is Weighted According to a Typical Consumer

The prices of goods do not rise or fall uniformly. They need not even move in the same direction. We’ve had decreasing prices in flat panel TVs for years while milk prices have slowly increased and oil has gone up and down more times than I can count. In order to make sense of all the fluctuating prices, the index weights categories of goods by different amounts. The weighting is designed to provide an overall gauge of consumer price changes in the overall economy. There is only a single CPI for all consumers so it is meant to represent a typical consumer. However, there are many reasons why consumers might behave differently or experience different rates of inflation.

One of these reasons is income. The share of household expenses allocated to categories such as housing, food, and entertainment vary significantly by income which can lead to different rates of experienced inflation.

Low Income Earners Spend More in Categories With Higher Inflation

In January, the inflation rate for food consumed at home and away from home were roughly equal at 3.7% and 3.9% respectively. However, since January, food prices at home have outpaced the rate of overall inflation with a YoY price increase of 11.9%. In contrast the rate of inflation for food consumed away from home now lags inflation at a rate of 7.4% This distinction is significant because income earners in the lower two quintiles spend more of the budget on food, especially food at home. This makes sense because someone with less disposable income is more likely to make their own meals where their same spending can provide more meals. It’s true that the higher rate of inflation in grocery prices wouldn’t matter if low income and high income earners had similar spending habits, but BLS data shows that low income earners allocate 10.8% of their expenditures to food at home which is 50% higher than the highest income quartile who allocate only 6.8% of their expenditures for Food at Home.

Differences in spending habits also exist for categories such as energy including electricity, natural gas, and gasoline which have increased substantially over the last year. For example, low income earners spend almost twice as much on energy as high income earners which is a category that has increased 35% over the last year. In contrast, high income earners spend more than low income earners on services including entertainment and insurance which have only increased by about 5% over the last year. This difference in spending behaviors results in different effective rates of inflation for low and high income earners.

Raises Haven’t Kept Pace With CPI

In order for consumers to have more purchasing power, incomes need to rise faster than the rate of inflation. With wage increases in 2021 ranging between 4-10% over 2021, there’s a good chance that your wages have not kept pace with the overall CPI. For low income earners who spend more within the categories of goods I described (e.g. groceries and electricity) and who experience higher rate of inflation than is stated in the CPI, wage increases are even less likely to have kept pace with inflation.

Homeownership Shields Owners From Inflation

As a homeowner with a fixed rate mortgage, my monthly debt payments are fixed but my shelter costs can still increase if my escrow costs increase. An escrow is a holding account that can be used for taxes and insurance. Unfortunately, taxes and insurance can increase each year which would increase my shelter costs. However, since the mortgage portion of my monthly payment stays fixed, I am likely to experience a smaller increase in shelter costs than someone who rents. Furthermore, since I was able to lock in a low 30 fixed rate mortgage in November at around 3% I’ve been able to benefit from a lower monthly payment. While I should have used a 10/1 ARM to get an even lower payment, I was worried about the tight financing timelines in the builder’s contract and went with their preferred lender and chose the path of least resistance. In hindsight I should have sought financing earlier in my homebuying process to establish a relationship with a mortgage officer like I had previously with my local credit union. Doing so would have enabled me to move quickly on financing as soon as the contract was signed and eliminated my hesitation to push for an adjustable rate mortgage.

Another reason homeowners are less likely to feel inflation is because home values have tended to keep pace with inflation over time. This was true for the 70s and 80s and has remained true for most of this century as well, the Great Recession notwithstanding. For a homeowner with leverage through a mortgage, the borrower further benefits from financial leverage; meaning that their relatively small amount of invested capital generates outsized returns. Financial leverage should always be used with caution but can be a great tailwind to increase returns that could later be used as cash for a future downpayment for another house.

Renters, on the other hand, are more likely to face changing shelter costs. Homeowners might own a property for 10 years before selling it a lease will often only last a single year. Each year when a renter signs a new lease they will be assessed market rates and those rates have increased substantially over the last 12 months. Using the Zillow Observed Rent Index, the average rent in the United States has increased 15.9% since May of 2021.

Low income earners in the first and second income quartiles have homeownership rates of 48% and 57% respectively and are more likely than the typical consumer to be renters and thus experience these higher rent prices. The highest earners have a homeownership rate of 87% and are less likely to be adversely affected by housing inflation because they are already in the real estate market.

Shelter as a Driver of Current Inflation Increases

Since I last wrote about inflation back in February, price inflation for shelter costs as reported by the BLS have moved somewhat closer to the Zillow Observed Rent Index (ZORI). However, a significant gap of 10.4% remains between the two measures. A convergence of these two values would longer or sharper inflation depending on how quickly or slowly they took to converge.

2018201920202021YoY
Zillow3.8%2.9%2.3%14.9%15.9%
CPI – Shelter3.2%3.2%1.8%4.1%5.5%

Difficult Choices

For a household in a higher income quintile that allocates more cash to entertainment and dining out, the budget cuts necessary to maintain their savings rate during inflation is less painful. The high income earner might be able to switch from eating out 6 times a week to twice a week without too much trouble. For someone who already eats out only once a week it is tougher to cut their dining expenses by a third to just once every three weeks.

What arguments have I left out that suggest that low income earners are more affected by current US inflation than high income earners? Are there counter arguments that I didn’t consider? Please leave your comments below

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