Starting out
Inflation
The rate at which prices rise, which means the rate at which each pound or dollar buys less.
How it works
Inflation is the reason cash is not a risk-free asset. At 3% inflation, money left in a drawer loses about a quarter of its purchasing power in ten years while its number stays the same.
It is also why returns should be thought about in real terms — after inflation — rather than nominal terms. A 5% return in a 6% inflation year is a loss, whatever the statement says.
Where it misleads people
The published inflation rate is an average across a basket of goods. Your personal inflation rate depends on what you actually spend money on, and for people with large rent or education costs it is often materially higher.
Formula
Real return ≈ nominal return − inflation rateWorked example
A savings account paying 4% during a year of 6% inflation delivered a real return of about −2%: the balance grew and what it could buy shrank.
Related terms
- Real returnReturn after subtracting inflation — the only measure of whether you got richer.
- Consumer price indexThe main official measure of inflation, tracking the price of a fixed basket of goods and services.
- Purchasing powerWhat your money can actually buy, rather than how many units of currency you have.
- Inflation-linked bondsGovernment bonds whose principal and coupons rise with an official inflation index.
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Educational reference only. Nothing here is investment advice or a recommendation to buy or sell anything, and tax treatment depends on your own circumstances and the country you are in.