Why does inflation compound, and what does it do to my savings over decades?

Inflation is quoted as a yearly rate, which makes it sound like a yearly problem. It is not: each year’s rise applies to prices that have already risen, so the price level compounds. Over a plan that runs thirty or forty years, a rate that looks small decides a great deal, and a spell of high inflation leaves prices higher for good.

How the price level compounds

The Bank of England’s example: at 2% inflation, a basket costing £100 a year ago costs £102 today. Next year’s 2% applies to £102, not to £100. Repeat it for decades and the effect is the same as compound interest, working against you.

Most central banks aim for about 2% a year: the US Federal Reserve (measured on personal consumption prices), the European Central Bank, the Bank of England and the Bank of Japan, while the Bank of Canada aims for the 2% midpoint of a 1 to 3% range. India’s target is 4%, with a tolerance band of 2 points either side, renewed in March 2026 to run until March 2031. A target is an aim, not a forecast, and actual inflation can run well away from it.

A high-inflation spell does not reverse

When inflation falls back, prices do not; they stop rising as fast. US consumer prices rose by an average of 8.8% a year from 1973 to 1982, against 2.8% in the thirteen years before, and the price level more than doubled over that decade. India’s consumer prices rose by an average of 10.3% a year from 2009 to 2013, against 4.9% from 2000 to 2008, a rise of about 63% in five years. In both cases everything afterwards inflated from the new, higher base.

Not everything inflates at the same rate

Some costs consistently outrun the average. In the United States, medical care prices rose by about 4.2% a year from 1984 to 2024, against 2.8% for all items, so they multiplied about 5.3 times while prices overall roughly tripled. Nivritee’s defaults give education and medical costs a higher rate than general inflation in every country it covers, for the same reason. A plan that grows school fees or health costs at the general rate understates them, and the gap widens every year until the bill arrives.

What it does to savings

The return that matters is the real return: roughly the nominal return minus inflation. Cash that earns 3% while prices rise 5% grows in number and shrinks in what it buys. Over 20 years it loses about a third of its purchasing power, even though the balance never falls.

• Plan consistently. Either keep everything in today’s money and use real returns, or keep everything in future money and use nominal returns. Mixing the two is the commonest error.
• Keep only what you need in cash: an emergency fund and money for near-term goals. Long-term money needs a return above inflation.
• Give the fast-rising costs their own rate rather than one blended figure.

How Nivritee handles it

You & your assumptions holds three inflation rates, General inflation, Education inflation and Medical inflation, defaulted from the country you will be living in and yours to change. Each cost rises at its own class’s rate, and the projection carries inflation as a running price level, so a high-inflation window leaves prices raised afterwards. Nivritee’s returns are nominal and inflation compounds separately, so nothing is counted twice. The stress test A sustained inflation shock adds 4 points to inflation for seven years, starting two years from now, and prices stay at the higher level; a plan for India also offers An India-style inflation run. See should I change the six assumptions and what each stress test assumes.