What is inflation and how does it affect your savings?

What is inflation?

Inflation is the general and ongoing rise in the prices of goods and services over time. It is not one product getting more expensive in a single month. It is the economy as a whole becoming more expensive, year after year. The direct consequence is simple: the same amount of money buys less than it did before.

That is why inflation is so closely tied to the idea of purchasing power. When prices rise 3% in a year, €100 at the end of the year buys roughly what €97 bought at the start. The number of euros in your account has not changed, but what they are worth has.

How is inflation measured in Portugal?

In Portugal, inflation is measured by the Consumer Price Index (CPI), calculated every month by Statistics Portugal (INE)¹. INE tracks the price of a representative basket of food, housing, transport, health and leisure, and works out how much, on average, that basket has become more expensive. The change in the CPI compared with the previous period is the inflation rate.

Across the euro area, the European Central Bank (ECB) targets inflation of 2% over the medium term². That is why 2% is often the reference figure used to project inflation over the long run, although in any given year it can be much higher or lower.

Year-on-year and average inflation

The news quotes two numbers that measure the same reality in different ways. Year-on-year inflation compares prices in one month with the same month a year earlier, answering "how much have prices risen over the last 12 months?". Average annual inflation compares the average of the last 12 months with the average of the previous 12, smoothing out one-off spikes¹.

The two can tell different stories in the same month: the year-on-year figure reacts faster to recent jumps (in energy prices, say), while the average takes longer to reflect them. Whenever you read an inflation figure, check which one is being quoted. The difference is between a snapshot of the moment and a film of the whole year.

What makes inflation rise?

Inflation has no single cause. In simple terms, prices rise when there is more demand than supply, or when producing things becomes more expensive:

• Demand-pull inflation: when demand for goods and services grows faster than the capacity to produce them, prices rise.
• Cost-push inflation: when production costs go up (energy, raw materials, wages), firms tend to pass them on in prices.
• Expectations: if everyone expects prices to rise, they act accordingly (asking for raises, raising prices pre-emptively) and the rise becomes self-fulfilling.

The European Central Bank tries to keep these forces in check, adjusting interest rates so that inflation stays close to 2% over the medium term².

Inflation, deflation and disinflation

Three similar-sounding words that mean different things:

• Inflation: prices, overall, are rising.
• Disinflation: prices are still rising, but more slowly than before. The inflation rate falls, yet stays positive.
• Deflation: prices are falling. The inflation rate is negative.

Deflation may sound like good news for shoppers, but it is a warning sign for the economy: if people delay purchases waiting for lower prices, spending stalls and activity slows. That is why central banks aim for low, stable inflation of around 2%², rather than its complete absence.

What is purchasing power?

Purchasing power is the amount of goods and services a given sum can buy. It is the honest way to look at money: what matters is not just how many euros you have, but what those euros buy.

Inflation compounds over time, just like interest. An average annual rate of i over n years multiplies prices by (1 + i)ⁿ. It is a compound effect: each year's rise applies on top of the already-higher prices of the year before. That is why even "low" inflation has a large impact when it runs for a decade or two.

How to calculate the loss of purchasing power

To find out what your money will be worth a few years from now, divide the amount by the cumulative inflation factor:

Real value = Amount ÷ (1 + inflation)ⁿ

And to find out what something you pay for today will cost in the future, multiply instead:

Future cost = Amount × (1 + inflation)ⁿ

Our inflation calculator does both at once and also shows the purchasing power lost and the cumulative inflation over the period.

Worked example

Imagine €1,000 and average inflation of 2% a year over 10 years:

• Cumulative factor: (1 + 0.02)¹⁰ ≈ 1.219 (prices rise about 21.9%).
• Real value: €1,000 ÷ 1.219 ≈ €820 of purchasing power.
• Purchasing power lost: about €180.
• Future cost: something that costs €1,000 today will cost around €1,219.

You can test your own numbers (amount, rate and years) in the inflation calculator and see the result instantly.

Inflation and wages

The same reasoning that applies to savings applies to your salary. A pay rise is only a real gain if it is above inflation. If your salary goes up 2% in a year when prices rise 3%, your purchasing power falls. In practice it is a cut of about 1%, even though you take home more euros at the end of the month.

That is why wage negotiations and pension or rent updates talk so much about "preserving purchasing power": the aim is, at the very least, to keep pace with inflation. When weighing up a pay-rise offer, always compare it with expected inflation. It is the only way to know whether you are genuinely getting ahead or just running to stand still.

How does inflation affect your savings?

This is the point that matters most to savers. What counts is not the nominal return (the interest shown on your statement) but the real return:

Real return ≈ net return − inflation

If a term deposit earns 2.16% net and inflation is 2%, the real gain is only about 0.16%, almost nothing. And if inflation outpaces the interest, the money loses real value, even while earning. Money left completely idle in a current account, with no interest, loses purchasing power in every year there is inflation.

How to protect money from inflation

There are no magic solutions, but there are sound principles:

• Don't leave large balances idle with no return. Even a capital-guaranteed product reduces the erosion.
• Compare the return with expected inflation, not the interest in isolation.
• Think long term: over many years, the effect of compound interest can help savings grow above inflation. The earlier you start, the more compounding cycles work in your favour.
• Diversify according to the risk you are willing to take and your time horizon.

For long horizons, it is worth comparing expected inflation with what each product earns in the compound interest calculator, and that is how you see whether your savings are actually gaining ground on prices³.