Inflation

Inflation is compound interest running against you. A price level rising 3% a year, the figure this entry uses as its example throughout, does not add 3% of today's prices every year; it adds 3% of last year's, so at 3% a year prices double in about 23 years and a dollar kept in cash buys half of what it does today. The rate is measured by pricing a fixed basket of goods and services every month and comparing it with the same basket a year earlier, and the figure moves from month to month. What it means for a household does not move: a raise, a return or a retirement budget is only as large as what is left of it after inflation.

In a sentence

• "With inflation at 3%, a $100 grocery run costs $134 in ten years and $181 in twenty."
• "Her raise was 2% and inflation was 3%, so the raise was a pay cut."
• "Inflation is prices rising. Lifestyle creep is your spending rising. Only one of them is your doing."

How it works

1. A price index tracks a fixed basket. Housing, food, transport, medical care and the rest of what households buy, priced every month.
2. The inflation rate is the basket's change over twelve months, as a percentage. A basket that cost $100 a year ago and costs $103 now gives 3%.
3. The rise compounds. Next year's 3% is on $103, not $100, so the price level follows the same curve as a balance earning interest.
4. Purchasing power falls by the same curve. A dollar in a given number of years buys what the price growth over those years leaves of it.
5. Every nominal figure has a real one behind it. A return, a raise or a benefit increase is worth its stated rate minus inflation, roughly, and the formula below exactly.

Price in n years = price today × (1 + inflation)^n

Real return = (1 + nominal return) ÷ (1 + inflation) − 1

The rule of 72 gives the doubling time without the exponent: 72 ÷ 3 is 24 years, close to the exact 23.4.

An example

What 3% inflation, the example's assumption, does over time to a $100 basket of groceries and to a $100 bill kept in a drawer.

The same arithmetic scales to any figure. A retirement budget of $4,600 a month today needs $8,308 a month in twenty years to buy the same things. And $10,000 kept in cash for ten years still reads $10,000 but buys $7,441 worth of today's goods; in a savings account at 4.00% APY, another example assumption, it grows to $14,802, which buys $11,014 worth; at a 7% investment return it grows to $19,672, which buys $14,637 worth. The nominal figures are the ones on the statements, and the real ones are the ones that say what happened.

Why it matters

Inflation decides what safe means. Cash is safe from losing dollars and certain to lose purchasing power, which makes it the right place for next year's money and the wrong place for money with decades to wait; a return, a raise and a pension increase all have to clear the inflation rate before they are gains at all. It also sets the scale of every long plan. A retirement thirty years out planned in today's dollars needs an inflated figure to be reached and a real figure to be understood, and a household that skips the conversion either saves toward a target that will not buy what it expects or is frightened by a nominal sum that means less than it looks.

Inflation versus lifestyle creep

Inflation is the same things costing more; lifestyle creep is buying more or better things as income rises. Both raise a household's spending from one year to the next, and the difference is who did it: a grocery bill that is 3% higher for the same cart is inflation, and one that is 15% higher because the cart changed is creep with inflation as its excuse. The same distinction separates nominal from real: a nominal figure is in the dollars of its own year, and a real figure restates it in today's dollars, so a rate of return of 7% in a 3% year was a real return of 3.88%, and a 2% raise in that year was a real cut of about 1%.

Common questions

Is inflation the same as the cost of living? No. The cost of living is what a given standard of living costs in a place at a time; inflation is the rate at which that cost rises. A city can have a high cost of living and low inflation at once.

Does inflation ever go down? The rate falls often, which means prices are still rising but more slowly. Prices themselves fall only in deflation, which is rare and brings its own problems, so a return to last year's prices is not something a household should plan on.

How do I protect savings from inflation? Match the money to its horizon. Keep the next year or two of needs in savings, where the interest offsets most of the loss, and put money with a decade or more to wait in investments whose expected return exceeds inflation. Cash held for decades is the one arrangement that is certain to lose.

Does inflation help people with debt? Yes, when the rate is fixed. A fixed-rate mortgage is repaid in dollars that buy less each year, so the real burden of the payment falls over time, which is the same effect that hurts a saver holding cash.

Why does my own inflation feel higher than the reported rate? Because the index is an average basket and yours is not. A household whose spending is mostly rent, childcare and medical care can see its own costs rise faster than the index in a year when the categories it does not buy stayed flat.

Go deeper

• The Retirement calculator projects what your retirement savings could grow to by the age you plan to stop working, what that is worth in today's dollars, and the monthly income it could support.
• The Compound interest calculator shows how a starting balance and a monthly contribution grow at a given return over the years, and its common questions cover what inflation does to the result.
• How to budget in retirement on a fixed income builds a budget for a household with no raise to absorb rising prices, with a yearly review that resets the numbers.