What is inflation? How it's measured and what it does to your money
Inflation is the rate at which the general level of prices rises, eroding the purchasing power of money. It is usually measured with a consumer price index.
What inflation is
Inflation is a sustained rise in the general level of prices. When it runs at 5%, a basket of goods that cost 100 a year ago costs 105 today — or, put the other way, the same money buys about 5% less. Mild, predictable inflation is considered normal in a growing economy; high or volatile inflation erodes savings, distorts decisions and makes planning hard.
Most major central banks aim for low, stable inflation: the US Federal Reserve and the European Central Bank both target 2% over the medium term.
How it is measured
Statistics offices track the price of a representative basket of goods and services — the consumer price index (CPI) — and compare it over time:
Annual inflation = (CPI now ÷ CPI 12 months ago − 1) × 100 Annualised from monthly = (1 + monthly rate)^12 − 1 Real return = (1 + nominal return) ÷ (1 + inflation) − 1
Analysts also watch core inflation, which strips out volatile food and energy prices to show the underlying trend. Monthly figures compound: prices rising 3% a month add up to (1.03)^12 − 1 ≈ 42.6% over a year, not 36%.
What it does to your money — a worked example
At 3% annual inflation, prices rise by about 34% over ten years (1.03^10 ≈ 1.34), so 100 units of cash buy only about 74% of what they used to. A savings account paying 2% loses purchasing power every year, even though its balance grows.
That is why investors focus on real returns. A deposit paying 10% while inflation runs at 7% earns only about 2.8% in real terms, before tax. In high-inflation economies the gap between nominal and real numbers is huge, and a price chart in local currency can look impressive while real wealth stands still.
Inflation and markets
Unexpectedly high inflation usually pushes central banks to raise interest rates, which tends to hurt bond prices and can weigh on stock valuations. Over long periods stocks have generally outpaced inflation because companies can raise their prices, though not reliably in the short run. Gold has been used as a store of value for centuries, but it is volatile and can lag inflation for years at a time.
Currencies react too: inflation persistently higher than in trading partners tends to weaken a currency over time, which is why exchange rates and inflation data are watched together.
Frequently asked questions
What causes inflation?
Broadly: demand growing faster than the economy's capacity to supply, rising costs such as energy or wages, a weakening currency that makes imports dearer, and expectations — if people expect prices to rise, they behave in ways that push them up.
What is the difference between inflation and core inflation?
Headline inflation covers the whole consumer basket. Core inflation excludes the most volatile items, usually food and energy, to show the underlying trend that central banks focus on.
How can investors protect themselves from inflation?
There is no perfect hedge. Assets whose value or income tends to rise with prices — equities over long periods, real assets, inflation-linked bonds — have historically held up better than cash. Diversification and a focus on real returns matter more than any single instrument.