Inflation is the rate at which the general price level rises over time. If inflation is 6% a year, a basket of goods costing Rs 100 today costs about Rs 106 next year. The number in your bank account has not changed. What it can buy has shrunk.
In India it is measured mainly by the Consumer Price Index, which tracks a basket weighted towards food, fuel, housing and services. The Reserve Bank of India operates a flexible inflation targeting framework, aiming for CPI inflation around 4% with a tolerance band of plus or minus two percentage points, and it adjusts the repo rate largely in response to it.
The compounding you did not sign up for
Inflation compounds exactly as compound interest does, just in the wrong direction.
At 6% a year, the purchasing power of Rs 10 lakh sitting in cash:
| Years from now | What it can buy in today's terms |
|---|---|
| 5 | About Rs 7.47 lakh |
| 10 | About Rs 5.58 lakh |
| 20 | About Rs 3.12 lakh |
| 30 | About Rs 1.74 lakh |
Nothing was stolen. No transaction appears anywhere. Over thirty years, roughly 83% of the value quietly evaporated while the balance stayed at Rs 10 lakh.
Real return is the only return that matters
Nominal return is what the product advertises. Real return is what you keep after inflation.
The approximation most people use is simply nominal minus inflation. A fixed deposit paying 7% while inflation runs at 6% gives a real return of about 1%.
Now apply tax, which is charged on the nominal figure, not the real one:
- FD interest: 7%
- Tax at a 30% slab: minus 2.1%
- Post-tax return: 4.9%
- Inflation: 6%
- Real return: about minus 1.1%
The deposit grew. The buying power fell. This is the trap in treating fixed deposits as a safe place for long-horizon money: safe from volatility is not the same as safe from erosion. See fixed deposit for how the tax works.
Why your personal inflation is usually higher
Headline CPI is an average across a national basket. Your own rate depends on what you actually spend on.
Education fees, private healthcare, domestic help and residential rent in Indian metros have frequently risen faster than headline CPI. Electronics and telecom have often risen more slowly or fallen. A young family paying school fees and rent experiences a materially higher effective inflation rate than the headline number suggests.
If you are planning for a child's education twenty years out, using 6% will almost certainly understate the bill.
What this means for planning
- An [emergency fund](/glossary/emergency-fund) should still be in cash-like instruments. Losing a little to inflation is the price of certain access, and it is worth paying for money you might need next week.
- Long-horizon money needs assets that can outpace inflation. Historically that has meant equity through a SIP or index fund, which is volatile in the short run and has beaten inflation comfortably over long periods.
- Retirement figures must be inflated. Rs 50,000 a month of expenses today becomes roughly Rs 1.6 lakh a month in 20 years at 6%. Planning on today's numbers is the most common and most expensive retirement mistake.
- Fixed income has a role, just not the whole role. PPF and EPF have historically stayed slightly ahead of inflation with the advantage of favourable tax treatment.
Test your own numbers with our inflation calculator.
Related terms worth knowing
Deflation is falling prices, which sounds pleasant and is generally a sign of a weak economy. Disinflation is inflation slowing down while prices still rise. Stagflation is high inflation combined with weak growth, the hardest combination for a central bank to fix, because raising rates to fight inflation weakens growth further.
The mistake to avoid
The most common error is not investing badly. It is treating cash as risk-free. A large savings account balance held for a decade "just to be safe" is a guaranteed loss in real terms, and it is invisible because the number on the statement never goes down.