Inflation and Purchasing Power

Why this matters

Every other lesson counts in dollars. This one asks what those dollars are worth. A plan that looks good on paper can quietly fall short if it ignores rising prices, especially over the decades that long-term investing covers.

What inflation is

Inflation is a general rise in prices across the economy. Not every price rises at once or by the same amount, but on average, things cost more over time than they used to.

In the US, one of the most common measures is the CPI, published every month by the Bureau of Labor Statistics.¹ It tracks the prices of a broad basket of things households buy, such as food, housing, transport, and medical care.

The flip side of rising prices is falling purchasing power: each dollar buys a little less than it used to.

What that looks like over time

Suppose prices rise a steady 3% a year. That's a hypothetical rate, chosen to keep the math simple.

• Something that costs $100 today would cost about $134 in 10 years.
• Put the other way, $100 kept in cash would buy what about $74 buys today.

Nothing dramatic happens in any single year, which is what makes inflation easy to overlook. The damage is in the accumulation, and it compounds, just like returns do.

Nominal and real returns

The return you see on a statement is the nominal return: the change in dollars. The return that tells you whether you're actually better off is the real return: what's left after inflation.

A simple estimate is:

Real return ≈ nominal return − inflation

	Nominal return	Inflation	Real return, roughly
Investment	5%	3%	+2%
Savings account	4%	5%	−1%

In the second row, the account balance goes up every year, yet the money buys about 1% less each year. The number on the statement grows while what it can buy shrinks. (The exact figures are slightly different, about 1.9% and −0.95%, but the estimate is close enough for most decisions.)

How inflation affects different kinds of money

• Cash and savings. Safe from market drops, but when the interest rate is below inflation, purchasing power falls.
• Fixed payments. Anything that pays a set number of dollars, like many bonds, loses value in real terms when inflation is higher than expected. Part 2 covers this in Why Bond Prices and Yields Move in Opposite Directions, and some bonds are designed to adjust for inflation: Inflation-Protected Bonds: TIPS and I Bonds.
• Businesses. Some companies can raise their prices when costs rise, which can help protect their owners. Not all can, and none can do it reliably in every period.

Is some inflation normal?

Yes. Mild, steady inflation is normal in most modern economies. In the US, the Federal Reserve aims for inflation of 2% a year over the longer run,² measured by a price index called PCE, which the Bureau of Economic Analysis publishes.³ Actual inflation can run well above or below that target for long stretches. Central Banks and Monetary Policy, in Part 6, covers central banks and why they target inflation at all.

Key takeaways

• Inflation means prices rise over time, so each dollar buys less.
• Real return ≈ nominal return − inflation. Only a positive real return increases what your money can buy.
• Cash is safe from market drops but fully exposed to inflation.
• Inflation's effect is small each year and large over decades.

Check your understanding

Your savings earn 3% a year and inflation is 4% a year. After one year, what has happened?

1. You have more dollars, and they buy more.
2. You have more dollars, but they buy slightly less.
3. You have fewer dollars, because inflation reduces your balance.

Someone keeps their retirement savings, 30 years away, entirely in cash because "it can't go down." Based on this lesson, what risk are they overlooking?

1. Over 30 years, inflation can greatly reduce what that cash can buy.
2. Cash can lose its dollar value in a market crash.
3. There is no risk; cash is the safest choice for any time frame.

What's next

This lesson and the last one both pointed to the same thing: time changes which risks matter most. The next lesson, Time Horizon and Risk Tolerance, is about how long your money can stay invested and how much ups and downs you can live with.