A savings account that pays 3% interest sounds like it is earning money. If inflation is running at 4%, it is not. The number in the account is rising, but what that number can buy is falling.
This is the difference between nominal returns (the number) and real returns (the purchasing power). Understanding this distinction is essential for long-term financial thinking, because inflation is silent, gradual, and relentless.
This is general educational information, not personal financial advice.
What Inflation Actually Does#
Inflation is the rate at which prices for goods and services rise over time. When inflation is 3%, something that costs $100 today will cost $103 next year, on average.
This means money sitting still loses value. Not in nominal terms (the number stays the same), but in real terms (what it can buy shrinks). A dollar today buys less than a dollar ten years ago, and will buy less still ten years from now.
Inflation is measured by indices like the Consumer Price Index (CPI), which tracks the cost of a basket of goods and services over time. In Australia, the Reserve Bank targets inflation of 2-3% per year.¹ This is considered healthy for the economy, but it still erodes purchasing power.
Nominal vs Real Returns#
Nominal return is the percentage gain on an investment before accounting for inflation. If an investment grows from $100 to $107, the nominal return is 7%.
Real return is the nominal return minus inflation. If that same investment earned 7% but inflation was 3%, the real return is approximately 4%. That 4% represents the actual increase in purchasing power.
The formula is:
Real Return ≈ Nominal Return − Inflation Rate
For more precision, especially over long periods:
Real Return = (1 + Nominal Return) / (1 + Inflation Rate) − 1
The difference matters. An investment that appears to be growing may actually be treading water or losing ground in real terms.
The Erosion Effect Over Time#
Inflation compounds, just like returns. A 3% annual inflation rate does not just take 3% per year. It takes 3% of a progressively smaller purchasing power base.
Here is what happens to $100 of purchasing power over time at different inflation rates:
| Years | 2% Inflation | 3% Inflation | 4% Inflation |
|---|---|---|---|
| 10 | $82 | $74 | $68 |
| 20 | $67 | $55 | $46 |
| 30 | $55 | $41 | $31 |
After 30 years of 3% inflation, $100 buys what $41 bought at the start. This is not a crisis scenario. This is normal, expected erosion.
An investment that merely matches inflation is not growing wealth. It is maintaining it. An investment that falls short of inflation is losing purchasing power, even if the nominal balance is rising.
Why "Safe" Assets Can Lose in Real Terms#
Cash and low-risk fixed-income investments are often described as safe. They are, in the sense that the nominal value is unlikely to fall. But they are not safe from inflation.
Historically, cash and short-term deposits have often failed to keep pace with inflation over long periods.² During times of higher inflation, the gap widens. An investor holding cash for decades may end up with more dollars but less purchasing power than they started with.
This is the hidden risk of avoiding all volatility. The assets that feel safest in the short term (because their prices do not move) can be the riskiest in the long term (because their real value erodes).
This does not mean cash is bad. Emergency buffers, short-term savings, and liquidity needs all require stable assets. But for long-term goals measured in decades, relying entirely on low-yield assets means accepting real losses.
How Different Assets Respond to Inflation#
Different asset classes have different relationships with inflation:
Cash and deposits: Typically lag inflation over long periods, especially when rates are low.
Bonds: Provide fixed income, which loses purchasing power when inflation rises. Long-term bonds are particularly sensitive. Inflation-linked bonds (like Treasury Indexed Bonds in Australia) adjust for inflation but may have lower nominal yields.
Shares: Historically, equities have delivered real returns above inflation over long periods.³ Companies can raise prices, grow earnings, and pass inflation through to customers. However, shares are volatile and can lose value in real and nominal terms in the short term.
Property: Real estate has historically provided some inflation protection, as property values and rents tend to rise with prices. However, property is illiquid, concentrated, and subject to local market conditions.
Commodities: Prices often rise with inflation, but commodities do not produce income and are highly volatile.
No asset class is perfect. The point is that inflation protection requires assets that can grow faster than prices, which usually means accepting some volatility.
Thinking in Real Terms#
A useful discipline is to always convert goals and returns into real terms.
If the goal is to have $1 million in 30 years, that means $1 million in today's purchasing power, not $1 million in nominal terms. Adjusting for 3% inflation, the nominal target would need to be closer to $2.4 million to have the same buying power.
Similarly, when evaluating investment returns, subtract inflation. A fund that returned 8% in a year when inflation was 5% delivered a real return of approximately 3%. That is the meaningful number.
This reframing changes how decisions feel. A 2% return on a savings account does not feel like a loss, but if inflation is 3%, it is. A 7% return on shares feels like a gain, but if inflation was 6%, the real gain was modest.
Visualising the Erosion#
A simple way to see inflation's effect is to project forward.
If you have $50,000 today and inflation averages 3% per year, in 20 years that money will have the purchasing power of approximately $27,500 in today's terms. The number on the statement might still say $50,000 (if held in cash earning nothing), but it will buy half as much.
Conversely, if that $50,000 is invested and earns a real return of 4% annually, it grows to approximately $110,000 in today's purchasing power. The difference between holding cash and investing is not just returns. It is whether purchasing power grows, holds steady, or declines.
Summary#
Inflation erodes purchasing power over time, making nominal returns misleading. Real returns (nominal minus inflation) show whether wealth is actually growing. Cash and low-yield assets often lose in real terms over long periods, even though they feel safe. Shares and other growth assets have historically provided inflation protection, but come with volatility. For long-term goals, thinking in real terms is essential: both the target and the returns should be adjusted for expected inflation. A positive nominal return can still be a real loss if inflation is higher.
Sources#
- Reserve Bank of Australia. (2024). Inflation target. https://www.rba.gov.au/inflation/inflation-target.html (Accessed January 2026)
- Dimson, E., Marsh, P., & Staunton, M. (2023). Credit Suisse Global Investment Returns Yearbook 2023. Credit Suisse Research Institute.
- Ibbotson, R. G., & Sinquefield, R. A. (1976). Stocks, bonds, bills, and inflation: Year-by-year historical returns. The Journal of Business, 49(1), 11-47.