What is Inflation, and how does it affect you?

In recent years, there has been a lot of buzz about inflation rates since it has remained high, hovering around 9–10 percent, which is unfavourable for a developing country like India. But why is Inflation given so much prominence, and what does it mean in reference to the Indian economy and how does it affect you?

What is Inflation?

Inflation is defined as an increase in the overall price of goods and services in a country. Inflation diminishes money’s buying power; the rupee loses value as the same sum of money buys fewer goods/services over time. You need more money to buy the same number of goods/services owing to Inflation.

In India, the Wholesale Price Index, or WPI, tracks the wholesale prices of a basket of items and is used to track inflation trends. This index analyses wholesale pricing rather than retail prices. The RBI primarily monitors WPI in order to make interest rate decisions.

How to Recognise When Inflation Is at Work

Some inflation is acceptable, as long as it stays under 2%, and some even indicate that the economy is doing well.

Utility stock prices: Because utility stocks are often very constant in terms of share prices and dividends, a long-term sell-off might result in an increase in Inflation.
When the price of raw materials rises, be cautious. An increase in raw material prices might be a leading indicator of Inflation.

Metals: You’ve surely heard that gold and silver are frequently used as inflation hedges. Although gold prices rise when the dollar falls, a spike in gold prices might signal Inflation.

Salaries: Wage push inflation occurs when wages rise, and companies are forced to raise prices to cover the increased wages.

What is the significance of the inflation rate?

Inflation has a significant influence on society, and as a consequence, you as a consumer and investor are affected. When Inflation rises, your money’s buying power decreases. As a result, the Rs 100 in your bank account will not be able to buy as much this year as it did the year before. To put it another way, you wind up paying more to maintain the same level of lifestyle.

If you’re investing for the near term with an interest-paying savings account, rising Inflation shouldn’t be a concern as long as your interest rate is higher than the rate of inflation. However, if you hold money in a current account that pays little or no interest, higher inflation rates will diminish the power of your investments.

What is the link between interest rates and Inflation?

Inflation and interest rates have an inverse connection, with one tending to lower as another rises. The Reserve Bank of India is responsible for determining the national interest rate, commonly known as the ‘base rate,’ in India. The government has set an inflation goal for the Reserve Bank of India. When banks calculate the interest rates they charge their customers; they consider the base rate.

Since they can earn excellent interest on their savings accounts, consumers will often spend a little less and more if the base rate is raised. As demand for goods and services declines, the inflation rate will diminish over time.

When interest rates are low, on the other hand, the economy grows because individuals are more likely to spend their money rather than save it. As a result, inflation is expected to rise.

Inflation and your saving account

Inflation isn’t good for your savings account. Recall that when Inflation rises, your money’s buying power decreases. So, if you’re accumulating for the long run and your income is in a checking account – or, even worse, underneath your bed — Inflation is slowly eating at that too.

To increase your cash savings, the rate of interest you get must be higher than the rate of inflation. You’re losing a lot of money if it isn’t. It’s better to utilise the rate of interest instead of the nominal interest rate when evaluating your interest earnings to the rate of Inflation.

The introductory interest rate of your account is the nominal interest rate, such as when a bank offers a savings account with 4.5 percent interest.

The real interest rate is the interest you receive after Inflation is taken into account – in other words, how much you’ve outperformed Inflation.

Subtract the inflation rate from the nominal interest to find the real interest you’re earning. So, if you make 4.5 percent interest on your savings and the inflation rate is 6.0 percent, the real interest you’ve earned is -1.5 percent. Cash, on the other hand, might be a fantastic location to keep your short-term savings and rainy-day.

What impact does Inflation have on investments?

While investing is a terrific way to save for the long run, Inflation can still affect your money. It all boils down to the many asset types you possess and how they react to Inflation.

• Comparable to cash savings, stocks and shares should be evaluated by comparing the real return on your assets to the rate of Inflation. For instance, if you made a 5% gain on your Stocks & Shares, but the inflation rate was 6%, you would have made a -1% return in absolute terms.
• Bonds frequently lose value during periods of rising Inflation, as greater Inflation reduces the buying power of future cash payments from the bond.
• Due to its’ safe-haven reputation, gold is well-known as a hedge against inflation. However, historical evidence reveals that gold does not always safeguard against Inflation.

Conclusion

Because of the extensive consequences of high Inflation, each emerging market economy must keep Inflation under strict control. Of course, you and I have little influence over Inflation, but we can add equity flavouring to our portfolios and stick to asset allocation to maintain our investments above Inflation.

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