Inflation and Real Returns

A loaf of bread cost about $1 in the US in the late 1990s; today it’s often closer to $2 or more. The bread hasn’t changed – the money has become worth less. This creeping process is called inflation, and it’s the reason cash under the mattress is not a safe investment in the long run, but one that is safely losing.

What inflation is and how it’s measured#

Inflation is the general increase in the price level over time. If prices rise 3% a year, after one year $100 buys what used to cost $97.

It is measured with a basket of goods: statistics agencies record the prices of hundreds of goods and services a typical household buys each month – food, rent, energy, clothing, insurance, travel. In the US that’s the Consumer Price Index (CPI); the Federal Reserve’s preferred gauge is the closely related PCE price index. The euro area uses the HICP, the UK the CPI published by the ONS.

Why there’s inflation#

Inflation arises when demand for goods grows faster than supply, or when costs – energy or wages, for example – rise and are passed on to customers. In the long run the money supply matters too: if it grows much faster than the economy, each unit of money loses value.

Central banks such as the Federal Reserve, the ECB and the Bank of England therefore aim for price stability, defined as roughly 2% inflation a year. Why not zero? Because falling prices – deflation – can set off a dangerous spiral: people delay purchases, companies invest less, debts become heavier in real terms. A small buffer gives central banks room to manoeuvre. More in Module 5.

Nominal and real#

Every return a bank or fund quotes is first nominal: it shows how many more dollars you have. What matters for your wealth is how much more you can buy. That’s the real return.

See for yourself what inflation does over longer periods:

Even the 2% considered “price stability” halves purchasing power in about 35 years. If you’re 40 and leave money in a checking account until retirement, you’ll end up with a fraction of today’s purchasing power.

Which investments protect against inflation?#

Over the long run, stocks have beaten inflation most clearly, because companies can pass rising costs on to customers. In the short run there’s no guarantee: in 2022 stocks and bonds fell together as central banks raised rates sharply to fight inflation.

Summary#

Inflation is every saver’s silent opponent. It’s measured with a basket of goods, targeted by central banks at about 2% and can run far higher in a crisis. What matters for your wealth is the real return. Long-term savers need returns above inflation – and historically, that has come mainly from real assets such as stocks.