Inflation: the slow leak in every dollar

A cup of coffee, a movie ticket, a month's rent: almost everything costs more than it did ten years ago. That steady rise in prices is inflation, and it is the quiet headwind every saver and investor flies against. It never takes money out of your account. Instead, it shrinks what that money can buy, which economists call purchasing power.

How inflation is measured

In the U.S., the headline number is the Consumer Price Index, published monthly by the Bureau of Labor Statistics. It tracks the prices of a broad basket of goods and services, from groceries and gasoline to rent and medical care. When you hear "inflation was 3% last year," it usually means the CPI was 3% higher than a year earlier. The latest reading is on the Pulse dashboard.

The Federal Reserve aims for 2% inflation over the longer run, measured by a closely related gauge. Reality has varied widely: U.S. inflation peaked near 15% in 1980 and reached 9.1% in mid-2022, the highest in about four decades. Since 1913 it has averaged roughly 3% a year, enough that something costing $1 back then costs more than $30 today. Try your own examples in the Inflation time machine.

The slow leak

Inflation compounds just like interest, only against you. At 3% a year:

The Rule of 72 works here too: 72 ÷ 3 = 24, so at 3% inflation prices roughly double every 24 years. Someone who retires at 65 and lives to 89 could see their cost of living double during retirement.

Nominal versus real

The return on your statement is the nominal return. What matters for your life is the real return: your return after inflation. A good rough formula:

Real return ≈ nominal return − inflation rate

• Savings at 4% with inflation at 3%: a real return of about 1%.
• Cash in a drawer at 0% with inflation at 3%: about −3%. You lose purchasing power every year, guaranteed.
• Stocks returning 10% in a year with 3% inflation: about 7%.

Taxes widen the gap. If your interest is taxed, a 4% savings rate might net closer to 3%, leaving almost nothing after inflation.

Why cash loses ground

Cash is essential. It belongs in your emergency fund and anywhere you need money within a few years. But as a long-term store of wealth, it tends to fall behind. Over long periods, assets that can grow with the economy, such as stocks, have historically outpaced inflation, while cash and safe short-term savings have often only roughly kept pace or slipped behind. That is the main reason long-term savers invest at all.

Some investments are designed specifically to keep pace. Treasury Inflation-Protected Securities (TIPS) and Series I savings bonds, both issued by the U.S. government, adjust with the CPI. They are tools worth knowing about, not automatic answers.

The opposite problem

Prices can fall, too. Sustained deflation sounds pleasant but usually signals a weak economy: people delay purchases while waiting for lower prices, and debts become harder to repay. The U.S. saw severe deflation in the early 1930s during the Great Depression, one reason central banks aim for low, positive inflation rather than zero.