Most people judge their financial progress in the currency they are paid in. A salary goes up, a portfolio statement shows a larger number, the house is valued higher than last year, and it feels like progress. Economists have a name for this habit. They call it money illusion, the tendency to think in nominal dollars rather than in what those dollars can actually buy.
Money illusion is harmless when inflation is low. It becomes expensive when inflation is high and persistent, because inflation works as a hidden tax: the erosion happens quietly, in the background, and nobody sends a bill. The economist Thomas Sowell once described inflation as the most universal tax of all. It requires no legislation, no vote and no announcement. It simply transfers purchasing power from savers and wage earners to borrowers, and the largest borrower in most economies is the government.
That observation feels unusually relevant this week. On Tuesday the Reserve Bank lifted the cash rate for a fifth time in 2026, choosing the one day of the year when a monetary policy decision has to compete with a horse race for attention. Americans, meanwhile, went to the polls in the midterm elections, against a backdrop of persistent inflation, a US$2 trillion budget deficit and 10 year bond yields that have spent much of the past two months above 5%.
Inflation has not gone away, it has settled in
In the United States, consumer prices rose 3.7% over the year to September. That marks more than five years of inflation running above the Federal Reserve’s 2% target. Real average hourly earnings, which adjust wages for inflation, fell 0.7% over the same period according to the Bureau of Labor Statistics. Put simply, the typical American worker received a pay rise and still went backwards.
Australia’s numbers are, if anything, less comfortable. The Australian Bureau of Statistics reported on 28 October that annual CPI inflation rose to 4.3% in September, up from 4.0% in August and above forecasts. The trimmed mean, the Reserve Bank’s preferred measure of underlying inflation, rose 1.0% in the September quarter and 3.7% over the year. Housing was the largest contributor, and fuel did much of the recent lifting.
On 3 November the Reserve Bank raised the cash rate by 25 basis points to 4.85%, its fifth increase this year and the highest setting since late 2008. The cash rate began 2026 at 3.60%. The Bank pointed to elevated inflation, the war in the Middle East and higher oil prices, and its new forecasts have inflation staying above target through much of 2027.
The more revealing detail was the vote. Six members of the Monetary Policy Board supported the increase and three wanted to hold, after September’s rise had passed unanimously. The statement also dropped September’s line about raising rates further if needed. Markets quickly read that as a sign the peak is close, and the Australian dollar slipped below US$0.70.
That reading may well be right. But it is worth being clear about what a pause would and would not mean. A pause stops the cost of borrowing rising further. It does nothing to reverse the price increases already in the system, and with inflation at 4.3%, the erosion of purchasing power continues whether the Reserve Bank moves again or not.
It is tempting to treat all of this as an energy story. The war with Iran has pushed up oil prices, and oil runs through transport, manufacturing and food. There is some truth in that. US core inflation, which excludes food and energy, was a more modest 2.6% in September. But the longer an energy shock persists, the more it seeps into wages, rents, insurance premiums and service prices. In Australia, with underlying inflation sitting near 3.7%, a good part of that seepage appears to have already happened.
The headline rate is not the damage, the cumulative rate is
Inflation rates are reported as annual figures, which hides their most important feature: they compound. A year of 4% inflation followed by a year of 4% inflation does not leave prices 4% higher. It leaves them about 8% higher, permanently. When inflation eventually falls back to target, prices do not fall back with it. They simply rise more slowly from a higher base.
This is why so many households report feeling poorer even in economies that look healthy on paper. The cumulative price level, not the latest monthly print, is what people experience at the supermarket, the petrol station and the rent review. For investors, the same arithmetic applies to returns. A portfolio that has compounded at 6% a year while inflation compounded at 4% has grown its purchasing power at roughly 2% a year, not 6%.
Inflation as a hidden tax, and why governments are in no hurry to fix it
Here is the second order effect that tends to get less attention. Inflation is uncomfortable for households, but it is quite convenient for heavily indebted governments.
The US federal government spent about US$7.4 trillion in the 2026 fiscal year while collecting about US$5.4 trillion in revenue, according to Treasury’s final monthly statement. The resulting deficit of US$1.99 trillion was 12% larger than the year before, and it was recorded during an economic expansion rather than a recession. Gross federal debt passed US$40 trillion in August, having roughly doubled in under a decade. Net interest payments now exceed US$1 trillion a year, more than the country spends on defence.
A government in that position has three broad ways out. It can raise taxes, it can cut spending, or it can allow inflation to erode the real value of the debt. The first two require votes. The third does not. This is not a conspiracy, and it is not unique to any one party or country. Both sides of American politics have overseen large deficits, and they disagree mainly on where the money should go. Whichever party controls Congress after this week’s vote will inherit the same arithmetic.
Bond investors understand this, which is why they have been demanding higher yields. The US 10 year Treasury yield climbed above 5% in mid September for the first time since 2023 and closed as high as 5.31% in early October before easing back to around 5% later in the month. A 5% yield sounds generous until it is set against 3.7% inflation. The real return is far thinner, and it carries the risk that inflation does not fall as quickly as hoped.
Even the Federal Reserve has learned this lesson the hard way. It bought trillions of dollars of bonds in 2020 and 2021, when yields were at historic lows, and as at the end of June was sitting on about US$878 billion of unrealised losses on that portfolio. Those losses do not threaten the Fed’s ability to operate, but they are a fairly vivid illustration of what happens to long duration assets bought at the wrong price when inflation returns.
The same tax, very different burdens
Inflation is often described as a tax on everyone, but it does not fall on everyone equally. Those who own real assets, such as businesses, property and equities, tend to see the nominal value of those assets rise with prices. Those whose wealth sits mainly in wages and cash tend to fall behind.
The US data shows how far this has gone. Federal Reserve figures, as compiled by Charlie Bilello, show the wealthiest 0.1% of American households now hold a record 15% of household wealth, while the bottom half holds about 2%. Americans in total now own more than US$60 trillion in stocks and mutual funds, more than three times the level of a decade ago. Asset owners have been compensated for inflation. Wage earners, for the most part, have not.
Australia has its own version of this divide, most visibly in housing. Those who owned property before the price surge have been carried along with it. Those trying to buy have watched higher prices and higher mortgage rates arrive together.
What this means for portfolios
The practical lesson is to judge investments in real, after tax terms, because that is the only measure that matters for long term wealth.
Consider a simple illustration. A term deposit paying roughly the new cash rate of 4.85% looks attractive in nominal terms, and after Tuesday’s decision it looks a little more attractive still. For an investor on a 30% marginal tax rate, the after tax return is about 3.4%. Set against annual inflation of 4.3%, the real return is roughly minus 1%. Five rate rises this year have not been enough to give that saver a positive real return. The account balance rises every year, and its purchasing power falls every year. That is money illusion in its purest form.
None of this means cash has no role. Cash provides liquidity, security and the ability to act when opportunities appear, and those are valuable things. But holding far more cash than needed, in the belief that it is the safe option, can be a slow and certain way to lose ground.
For long term investors, the more useful question is which assets can keep pace with rising costs. Businesses with genuine pricing power, those able to pass on higher costs without losing customers, have historically protected real wealth better than most. So have real assets with revenues linked to inflation, such as certain infrastructure and property, provided they were bought at sensible prices and are not overburdened with debt. Balance sheets matter more when interest rates are high, because refinancing becomes more expensive and the margin for error narrows.
Equally, investors should be wary of long duration assets priced as though inflation and interest rates will quickly return to the levels of the last decade. Bonds bought at very low yields, and growth companies valued on profits many years away, are the assets most exposed if inflation proves stickier than expected.
Risks and counterpoints
It is worth being careful here, because inflation forecasting has humbled many confident people in recent years.
Inflation could fall faster than expected. Energy shocks can reverse quickly. A ceasefire or a sustained fall in oil prices would pull headline inflation down sharply, and US core inflation of 2.6% suggests the underlying problem there may be smaller than the headline implies. Central banks have also shown they are willing to act. The Reserve Bank has now raised rates five times this year, the cash rate sits above most estimates of neutral, and the full effect of that tightening has not yet reached household budgets.
There is also a risk in the opposite direction. Higher interest rates can tip economies into slowdown, which would change the investment backdrop quickly. In that scenario, high quality bonds can become very valuable again, and the investors who locked in yields above 5% may look rather wise.
Finally, the fiscal story is a slow one. Large deficits and rising debt have worried investors for decades, and markets have shown remarkable patience. It would be a mistake to build a portfolio around a prediction of crisis. The more sensible conclusion is that persistent deficits make it harder for inflation and interest rates to return to the lows of the past decade.
TAMIM Takeaway
Inflation is running at 3.7% in the United States and 4.3% in Australia, real wages in the US are falling, and the Reserve Bank has just lifted the cash rate to 4.85%, its fifth increase this year. Behind the monthly figures sits a larger and slower story: governments carrying record debt have a quiet incentive to tolerate inflation, because it erodes what they owe without anyone having to vote for it.
A divided board suggests the rate cycle may be close to its peak, but a pause in rate rises is not a reversal of the price rises already absorbed. The market may also be missing how much of this is structural rather than temporary. The 5% bond yield is a signal that lenders want to be compensated for that risk. For long term investors, the right response is not panic, and not a heroic bet on inflation or on crisis. It is discipline: measure returns in real, after tax terms, avoid holding excess cash in the belief that it is safe, favour businesses and assets with genuine pricing power and sound balance sheets, and be careful about paying high prices for assets that only work if rates fall. The tax nobody votes for is still a tax, and the best defence is to own things that keep pace with it.