Understanding Inflation

  • Life Insurance

Over the last few years we have witnessed how food prices have risen dramatically. A pack of 100gm biscuits which cost Rs. 4 now costs Rs. 6 while you could get a 100gm bar of chocolate for Rs. 10 a couple of years back, the same Rs. 10 can only get you 75 gm of chocolate today. This signifies a fall in the purchasing power of money due to a rise in prices. The rate of change in the level of prices of goods and services over a period of time, which affects the purchasing power of money, is termed as inflation.

There are different metrics to track inflation such as Wholesale Price Index (WPI) and Consumer Price Index (CPI). Globally, CPI is the most widely used index as it measures the increase in price that a consumer pays for goods and services. It is also considered as a 'cost of living' index. However, in India WPI is more commonly used. It measures the change in the average price level of a basket of 435 products traded in wholesale markets. The WPI data is announced on a monthly basis

Inflation eats away not only in to savings but also the returns. It reduces the purchasing power of money, thereby reducing the intrinsic value of an individual's savings. Further, it also reduces the real return which is obtained by subtracting the inflation from nominal returns. For e.g. an investment of Rs 1,00,000 in a bank fixed deposit in January 2012 at an interest rate of 10% pa would get you Rs. 1,10,000 in January 2013. However, during this period inflation was 7.2%, thereby reducing your real rate of returns to mere 2.8%.

Household savings could be seen as either postponed consumption or money put away for wealth creation. If households save on account of postponed consumption then it would be very important that their returns on their savings beat inflation, if they have to be better off, in future. Inflation acts as a tax on your earnings, reducing your ability to spend and forcing you to postpone consumption.

A minimum level of inflation is considered good for the economy as it signals that the economy is growing. It encourages production, investment and consumption in the economy. It is also good for the stock markets as prices of stocks rise in line and companies also report higher profits. Inflation is one of the important factors that influence monetary policy decisions. Anchoring inflation expectations and maintaining price stability is one of the key macroeconomic objectives of the Central Banks across the globe.

To protect from loss on account of inflation it is essential to invest carefully as well to diversify your portfolio. Historically, over long-term, equities have provided the best hedge against inflation as equities have delivered over 19.1% CAGR (as on 31st December 2012) over the last 10 years. Along with financial assets, investing a portion of your savings in physical assets such as real estate or gold can neutralize the impact of inflation.

By far the most important statistics for both, the household and RBI is inflation. The RBI governor in a recent speech candidly says that even he does not know how to interpret inflation. "Twenty years ago, when I had a thick mop of hair, I used to pay Rs. 25 for a haircut. Ten years ago after my hair started thinning I was paying Rs. 50 for a haircut. And now, when I have virtually no hair left, I am paying Rs. 150 for a haircut".

Arpita Nanoti
Head – Investment Communication & Advisory

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