Understanding Inflation & It’s Impact On Investors / Consumers

Inflation in simple terms means general price rise of goods & services in a country. Inflation monster reduces purchasing power of money, rupee loses value with inflation as the same amount of money buys

lesser goods/services with time or to buy same quantity of goods/services you need more money due to inflation. In India inflation trend is broadly measured by Wholesale Price Index popularly known as WPI, tracking wholesale prices of basket of goods. This tracks prices at wholesale level and not the prices at which consumers buy goods. RBI mainly tracks WPI to take decisions regarding interest rates & money supply. In recent times too much fuzz is created around inflation numbers as it remains at elevated level of around 9 – 10% range which is not desirable for a growing economy like India. But why so much attention is given to WPI numbers and what is their significance in context of Indian economy?

WPI in India has very wide implications as many nodal agencies use WPI number to arrive at many important policy decisions. RBI uses this number to decide on interest rate & money supply measures, movement in WPI indicates price trend of essential commodities.

What causes inflation in a country ? 
As said earlier, inflation is nothing but general trend of price rise in a country. There can be multiple factors responsible for this trend of price rise:

Excess Money Supply: If money supply is increased due to loose monetary policy & low interest rates, prices go up as too much money chase too few goods. That is the reason why central banks increase interest rates in inflationary environment to reduce money supply.

High Level of Economic Growth With Low Investment: If economy is growing at healthy rate then income level of working population goes up and people start buying more goods and services which result in higher demand. To match this higher demand country needs to invest heavily in manufacturing sector to increase supply to match increased demand. If country fails to increase supply of goods & services against rising demand then it results in inflationary trend. Classic example is India where economy grew at a healthy pace of 9% in 2006-08 but manufacturing growth failed to keep pace with economy growth, and this resulted in higher inflation during the period between 2008 to 2012.

Deficit Financing : Emerging economies like India always remain in need of capital to finance various growth projects. As their imports remain higher than exports many a times governments of these countries lean towards deficit financing as a tool to fill the gap and narrow down the deficits. Deficit Financing means printing more currency to fill the deficit. This results in increase in money supply.

Impact of Inflationary Trend on You & Me (As Consumer – As Investor)
With rising prices from food to vegetables to petrol, common man like you and me always remain at the receiving end during high inflation environment. As discussed earlier in high inflationary environment on one end RBI keeps raising interest rates in an attempt to control inflation & on other end rising prices pinch common man’s household budget. CPI (Consumer Price Inflation), the inflation number that impacts common man more than WPI as it is the measure of price rise at end user level has remained at around 9 to 10% level in last few months.

Higher inflation, rising interest rates, higher input cost & lowering demand affects corporate profitability and results in lower production, eventually affecting the economic growth of the country. If inflation remains at the elevated levels for longer period of time it affects investors as investment in fixed income instruments end up generating negative real return. With CPI hovering around 9 to 10% and your investment in Bank F.D., PPF or any other Postal instruments generate 8 to 9% return, as an investor you end up generating negative return.

The logical alternative for investor is to explore investment avenue with possible inflation beating returns like equity & gold. Investing systematically & in a staggered manner help investors in yielding inflation beating returns.

Financial Planning & Inflation:
Inflation is the single most important factor to be considered while planning for all your future goals. Considering an appropriate inflation number while estimating future cost of your financial goal determine your asset allocation & return expectation.

e.g. If higher education costs Rs.5 lacs today with inflation expectation of 7% this can grow to Rs.9.8 lacs in 10 years time if your kid is of 7 years of age and higher education age assuming at 17 years.

With ever rising cost of living due to inflation it is very important for investors to look at investment class which can consistently generate inflation beating returns. Time & again it is proved that equity can consistently beat inflation over a long period of time and so it is imperative to have equity allocation in your portfolio to keep your investment portfolio floating above inflation level.

Because of the negative cascading effect that high inflation can have on overall economy, high rate of inflation is not favorable specially for a growing economy like India. High growth rate with reasonable inflation of between 4 to 6% could be an ideal scenario for the economy and that is the reason why RBI is desperately trying to bring inflation level down to around 5 – 6% range.

Due to widespread implications of high inflation, it is mandatory for any emerging market economy to keep inflation under tight control. Controlling inflation is of course beyond control of you & me, but we can definitely add equity flavor in our portfolio and follow asset allocation to keep our investment floating above inflation.