Inflation: why cash slowly loses value

Inflation is the quiet reason money under the mattress shrinks. Understanding it explains why savers look for interest or growth, and why a 'safe' account can still lose spending power.

What inflation is

• The Bank of England defines it simply: 'Inflation is when prices rise and how quickly they do so is called the rate of inflation.'
• The IMF describes inflation as how much more expensive a set of goods and services has become over a period, usually a year.
• The Bank of England's example: if something costs 10 pounds and prices rise by 2 per cent, it costs 10.20 pounds; a 1,000 pound item rising 2 per cent costs 20 pounds more.
• In the UK, the Bank of England's job is to keep inflation at a target of 2 per cent set by the government. It explains that a small amount of inflation helps avoid deflation, which can lead to lower incomes and higher unemployment.

How it is measured

• Most countries measure inflation with a consumer price index (CPI): the price of a 'basket' of typical things people buy.
• In the UK, the Office for National Statistics tracks the prices of about 700 items each month, according to the Bank of England.
• The IMF gives the basic calculation: if the CPI was 100 in the base year and is now 110, inflation over that period was 10 per cent.
• Your own inflation can differ from the official figure, because your 'basket' (rent, transport, food, phone) may not match the average.

Why cash loses purchasing power

• The IMF explains that if incomes do not rise as much as prices, purchasing power and real (inflation-adjusted) income fall. The same logic applies to money sitting in savings.
• Worked example: if prices rise by 3 per cent a year, AED 1,000 kept as cash buys only what about AED 744 buys today after 10 years, and about AED 554 after 20 years.
• Put the other way: something that costs AED 1,000 today would cost about AED 1,344 after 10 years of 3 per cent inflation.
• Inflation is uneven: some prices jump, others fall. The IMF calls this erosion of real income 'the single biggest cost of inflation'.

Real returns: beating inflation

• Your real return is roughly your interest or investment return minus inflation.
• The IMF's example shows this from the other side: a borrower paying a fixed 5 per cent while inflation is 5 per cent faces a real interest rate of zero.
• Worked example: AED 1,000 earning 2 per cent a year while prices rise 3 per cent a year is worth about AED 907 in today's money after 10 years. The balance grew, but its spending power shrank by roughly 1 per cent a year.
• The Bank of England notes that higher savings rates mean more money paid into your account, so it is worth comparing rates rather than leaving savings in an account that pays nothing.
• This is why people with long time horizons consider investments that may grow faster than inflation, while accepting that those investments can also fall.

What inflation means for your plans

• Short-term savings (emergency fund, next year's laptop) still belong in cash, because certainty matters more than growth over a few months.
• For goals 10 or more years away, inflation is a real cost of holding only cash.
• When planning a future goal, assume prices will be higher by then. A university cost estimate made today may be too low in five years.
• Bonds and savings with a fixed rate lose real value if inflation rises above that rate; Investor.gov lists this 'inflation risk' as a key bond risk.