What is inflation, and how does it shrink your savings?

Inflation is the general rise in prices over time, which means each dollar buys a little less each year. Cash that earns nothing loses buying power, so money you won't need for many years usually needs to grow faster than prices.

Inflation is measured with a price index

In the US, the Bureau of Labor Statistics publishes the Consumer Price Index (CPI) each month. It tracks the prices of a basket of goods and services that households buy.

Small rates add up

At 3% a year, prices rise by about 34% over 10 years, because each year's increase builds on the last. That is compounding working against you.

Cash keeps its number but loses buying power

A $1,000 bill stays $1,000. What changes is how much it can buy, which is why money held in cash for decades tends to shrink in real terms.

Real return is what counts

Your nominal return is the number your account shows. Your real return is that number minus inflation, which tells you whether your buying power actually grew.

What inflation is

Inflation is a broad, ongoing rise in prices across the economy. One item getting pricier, like eggs after a bad harvest, isn't inflation on its own. Inflation is when rent, food, gas, insurance and most other things all creep up together.

The Federal Reserve aims for inflation of 2% a year over the long run. Actual inflation is sometimes much higher or lower than that, and it varies from year to year.

How inflation is measured

The Bureau of Labor Statistics (BLS) collects prices each month for a basket of goods and services, from groceries and rent to medical care, and publishes the Consumer Price Index. The change in the CPI over 12 months is the inflation rate you hear in the news.

Your own inflation can differ. If rent is a big share of your spending and rents near you are rising fast, your costs may rise faster than the CPI. Tracking your spending shows how your own prices are changing.

Why cash loses value

Cash in a drawer or a checking account paying close to nothing keeps the same dollar amount while prices rise. Each year, the same amount buys less.

That is fine for your emergency fund and short-term goals, where safety matters most. Keep that money in an insured savings account that pays interest, so it loses less. For goals more than 5 years away, holding only cash means falling behind prices year after year.

Real vs nominal returns

A nominal return is the plain percentage your account earns. A real return subtracts inflation. If your savings earn 4.5% and inflation is 3%, your real return is about 1.5% a year. If your savings earn 1% while inflation is 3%, your real return is about −2%.

Investments like broad stock index funds have historically tended to beat inflation over long periods, but returns vary and can be negative for years at a time. That is why examples on this site label any return as an assumption and say whether it is before inflation.

Ways to protect your buying power

Earn interest on cash you must keep. Invest money for long-term goals in a diversified mix that fits your time horizon. Raise your savings when your pay goes up.

The US Treasury also sells bonds built for inflation. Series I savings bonds and Treasury Inflation-Protected Securities (TIPS) adjust with the CPI. They have their own rules on holding periods and taxes, so read the TreasuryDirect pages before buying.