Inflation: why cash slowly shrinks
A $20 bill under your mattress loses value every year without you noticing.
Prices creep up
Inflation is the general rise in prices over time. If a sandwich costs $10 this year and $10.30 next year, that is 3% inflation for sandwiches. When inflation is 3%, your same dollar buys about 3% less stuff each year.
In the US, inflation is commonly measured by the Consumer Price Index (CPI), which tracks the price of a basket of everyday goods and services. The Federal Reserve, the US central bank, aims for inflation of about 2% a year over time. Many other countries' central banks have similar targets.
Real vs nominal
A nominal return is the number you see. A real return is what is left after inflation. If your savings account pays 2% and inflation is 3%, your balance goes up, but your buying power goes down by roughly 1%.
That is the hidden cost of keeping long-term money in cash. It feels safe, because the number never drops. But its buying power can quietly shrink.
What this means for you
Cash is still the right tool for short-term needs and emergencies. Inflation is mostly a problem for money you will hold for many years. That is one reason people invest long-term money in things that have historically tended to grow faster than inflation, accepting more ups and downs in exchange.
If prices rise 3% a year, something that costs $1,000 today would cost about $1,344 in 10 years.
Flip it around: $1,000 kept in cash would buy only about 74% as much after 10 years. Using the Rule of 72, at 3% inflation prices roughly double in 24 years, which means cash loses about half its buying power over that time.
Key terms
- Inflation
- The general rise in prices over time, which reduces what each dollar can buy.
- Real return
- Your return after subtracting inflation. It measures the change in buying power.
- CPI
- Consumer Price Index, a common US measure of inflation based on prices of everyday goods and services.
Cash that earns less than inflation keeps its number but loses its buying power.