Inflation

Before you rely on it

What to check

Run any multi-decade projection in real terms as well as nominal, and say which one you are quoting.

The common error

Where people go wrong with inflation

Mixing the two. A nominal return paired with today's spending produces a plan that looks funded on the spreadsheet and comes up short in the life.

Worked through

Inflation in plain numbers

Prices rise 3% a year. Something that costs $100 today costs $100 × 1.03²⁰, or $180.61, in twenty years. Turned around, $100 of cash then buys what $55.37 buys now, a loss of about 45% in purchasing power; a savings account paying 2% in a 3% inflation year earns a real return of roughly −1%; the nominal balance rises while the ability to buy goods falls. Over long periods, inflation quietly matters as much as taxes or fees. That is why retirement plans project costs forward and why fixed incomes lose ground over time.

Easily confused

Inflation and its neighbours

Inflation is not the same as a single price rise or the price level; it is the rate at which prices in general rise. Deflation is falling prices. Disinflation is a slower rate of increase, where prices still rise. Core inflation excludes food and energy to reduce volatility. Different indexes measure it differently, and your own inflation rate depends on what you buy. Stagflation combines high inflation with weak growth. When a news report says inflation fell to 2%, it does not mean prices dropped, only that they rose more slowly.

In real decisions

Where inflation turns up

Inflation figures adjust wages, pensions, benefits, tax brackets and contracts; investors compare returns with it to find real returns; planners use it to project retirement costs. Businesses use it in pricing. Central banks set policy against a target. A calculator converts money across years, showing what an amount then would be worth now or how much you would need later to buy the same goods. Renters and borrowers with fixed payments benefit when inflation is high.

Know the edges

Where inflation stops being reliable

Published indexes are averages and may not match a household's experience. Different goods rise at different speeds, and quality changes are hard to measure. Forecasts of future inflation are uncertain and can be far off, and a calculator applies a constant rate, whereas real rates vary; use scenarios for planning, and review assumptions regularly. Official statistics are the source for actual measured inflation.

Quick answers

What people ask about inflation

How is inflation measured? By tracking prices of a basket of goods and services over time, then reporting the percentage change in an index. Different indexes use different baskets.

Does inflation affect savings? Yes. If your interest rate is lower than inflation, your purchasing power falls. Inflation-linked bonds and some real assets aim to keep pace.

Why do central banks target a small positive rate? A low, stable rate is thought to support growth and leave room to cut interest rates in a downturn. Targets vary by country.