7% against 3% inflation is 3.883%, not 4%
The approximation simply subtracts: 7 − 3 = 4%. The exact Fisher equation divides instead — (1.07 / 1.03) − 1 = 3.883% — because the inflation adjustment applies to the whole grown balance, not just the principal. The 11.7 basis point gap is small here and grows with both rates.
At higher levels it stops being a rounding difference. A 40% nominal rate against 30% inflation approximates to 10% and is exactly 7.69%, a quarter of the return gone. In high-inflation economies the approximation is not usable, which is why the exact form is the one central banks and bond markets work with.
Money in a 2% account during 5% inflation loses 2.86% a year
When inflation exceeds the nominal rate, the real rate is negative and savers lose purchasing power while their balance grows. This was the condition across most developed economies for much of the 2010s and again in 2021-22, and it is not an anomaly — it is a deliberate policy outcome when central banks hold rates below inflation to support demand.
The consequence for savers is direct: a nominally positive return can be a real loss, and cash held through a period of negative real rates is being quietly taxed. It also transfers value from lenders to borrowers, since debts are repaid in money worth less than when borrowed, which is part of why inflation erodes the real burden of fixed-rate mortgages and government debt alike.
The real rate you agreed to is not the one you got
When a rate is set, the real return depends on inflation that has not happened yet. Lenders price in expected inflation; what they actually earn depends on realised inflation. A period where inflation surprises upward transfers value to borrowers, and one where it surprises downward does the reverse.
Markets provide a read on expectations through the gap between nominal government bonds and inflation-linked ones — the breakeven inflation rate. Comparing that against the realised figure afterwards is how the surprise is measured, and over 2021-22 that surprise was among the largest in forty years.
Tax, which is charged on the nominal return
Tax is applied to nominal interest, not real. A 7% return taxed at 30% leaves 4.9% nominal, which against 3% inflation is a real after-tax return of about 1.84% — less than half the pre-tax real rate. In periods of high inflation and positive nominal rates, tax on the inflation component alone can turn a positive real return negative.
The calculation also uses one inflation figure, while the relevant rate is the one applying to whatever you would otherwise buy. For someone whose spending is concentrated in a category rising faster than the index, the effective real return is lower than the headline calculation suggests.
Sources & References
Figures on this page are checked against primary, authoritative sources. Links open in a new tab.