Understanding Inflation
Inflation affects every part of the economy, including consumer spending, company investment, and employment rates, as well as government programs, tax policies, and interest rates.
Inflation can lower the value of investment returns, therefore investors must have a firm grasp on it. With inflation reaching its high level in a decade after several years of relative quiet, investors may benefit from understanding the reasons driving inflation, its influence on their portfolios, and strategies to consider as the investment environment shifts.
Inflation is described as an increase in the prices of the majority of everyday products and services, such as food, clothing, housing, recreation, transportation, consumer staples, etc. In other words, Inflation Rate is the average change over time in the price of a basket of goods and services.
Example: Last week, you bought 5 kg of rice for Rs.100. This means that Rs. 20 was paid for 1 kg of rice. This week, when you went back to the same shopkeeper to buy rice and gave him Rs.100, he only gave you 4 kg of rice. He also said that the price of rice has gone up and that it now costs Rs.25 per Kg.
This clear example shows how the value of money has gone down. Before, you could get 5 kg of rice for Rs. 100, but now you can only get 4 kg of rice. So, people could buy less with their money. This is called inflation. And let’s figure out the inflation rate (percentage). If the price of rice, which was Rs.20 per kg, went up to Rs.25, this would mean that the price went up by Rs.5, or by 25 percent. So, the inflation rate is 25%, which is clearly a very high rate.
How To Measure Inflation Rate in India
If inflation isn’t controlled, it can destroy the whole economy. There are many examples of how high inflation rates destroyed economies in Africa and South America. But who in India keeps track of the inflation rate? And what kinds of inflation indices are there in India? Let’s look at each one.
There are three ways to measure inflation: at the producer, wholesaler, and retailer levels (consumer). Prices tend to go up at each level until the good finally gets to the consumer.
- Inflation At The Producer Level:
There is currently no index in India that measures inflation at the producer level. A Producer Price Index (PPI) is proposed, although this method of calculating inflation has not yet been implemented in India.
- Inflation At The Wholesale Level:
In India, this method of calculating the inflation rate is the most common. The Wholesale Price Index is the index used to calculate wholesale inflation. This rate of inflation is frequently referred to as headline inflation. The Ministry of Commerce and Industry publishes WPI.
Prior to 2014, RBI employed WPI for the majority of its policy decisions. WPI-based inflation calculations, however, were not erroneous proof. WPI displays the total cost of a commodity basket made up of 697 items. WPI excludes services and does not reflect the bottlenecks between the wholesaler and retailer or between the manufacturer and wholesaler (consumer). Therefore, starting in 2014, the RBI switched to using CPI for policy decisions as part of the changes spearheaded by RBI governor Raghu Ram Rajan.
- Inflation At the Retail Level:
Consumers frequently buy straight from retailers. Thus, the inflation experienced in retail stores is an accurate mirror of the national price increase. It also displays the cost of living more clearly.
In India, the index that indicates the retail inflation rate is known as the Consumer Price Index (CPI). CPI is based on goods but also includes some services. There were four Consumer Price Indices that represented distinct socio-economic segments throughout the economy. These four indices included the Consumer Price Index for Industrial Workers (CPI-IW), the Consumer Price Index for Agricultural Laborers (CPI-AL), and the Consumer Price Index for Rural Laborers (CPI-RL), and the Consumer Price Index for Urban Non-Manual Employees (CPI-UM) (CPI-UNME). CPI now uses a new series using the base year 2010=100 for all of India and States/UTs individually for rural, urban, and combination categories. Consumer Price Indices are published by the Central Statistics Office (CSO), Ministry of Statistics, and Program Implementation. This index is also used to compute the Dearness Allowance (DA) for government employees and is based on retail prices.
Having explored inflation rate measurement at various levels, let’s examine two inflation-related concepts. There are two types of inflation: headline and core.
- Headline inflation:
Headline Inflation is the overall inflation rate within an economy. It includes food, petrol, and all other commodity price increases. Typically, the inflation rate given in terms of the Wholesale Price Index (WPI) represents headline inflation. Though Consumer Price Index (CPI) readings are frequently higher, WPI values are traditionally the subject of news coverage.
- Core Inflation (Non-food Inflation):
Core inflation is another phrase used to describe the extent of an economy’s inflation. But Core inflation does not account for food and fuel prices. This idea is taken from the headline rate of inflation. Core inflation is currently evaluated by subtracting food and fuel from the Wholesale Price Index (WPI) and the Consumer Price Index (CPI).
Why Is India’s Current Inflation Situation a Concern?
Unprecedented inflation has seized the Indian economy. According to government figures, the annual inflation rate in India surged to 6.95 percent in March 2022, the highest level since October 2020. Likewise, the wholesale price index in March was the second highest since 2012, at 14.5%. Evidently, India’s economy confronts a double whammy as a result of the present inflationary spike, which is a result of the significant price increase of crude oil (which rose to 83.56 percent in March from 55.17 percent in February) and other commodities worldwide. This has increased the cost of imports for certain key goods. In addition, the Russia-Ukraine conflict has caused a disruption in the global supply chain. Notably, 85 percent of India’s oil requirements are met by imports.
Recently, and for the first time since 2018, India’s central bank, the RBI, increased the repo rate by 40 basis points to 4.4% as part of its anti-inflationary policies. The RBI cut rates in March 2020 to assist the economy in mitigating the risks posed by the Covid epidemic.
In light of the global economic slump, the significant purpose of the central bank’s rate increase is to manage and monitor the flow of money into the banking system. Inflation must be brought under control, according to the RBI, if the Indian economy is to continue on its path toward equitable and sustainable growth.
Consequently, as a result of the increase in the repo rate, bank loan EMIs will increase, impacting the consumer’s ability to save or invest and generate a return. Consequently, investment decisions must be prudent. To combat negative growth, a customer must select investment products with returns exceeding the rate of inflation.
Impact On Different Asset Classes
Inflation is a crucial and cyclical macro indicator that affects the activities of all sectors in the economy, whether they be central banks, government authorities, producers, or consumers. Due to its far-reaching repercussions, even capital markets must be sensitive to the numerous causes that could trigger fluctuations in inflation across varying time frames. At the most fundamental level, inflation also affects the profits that an investor obtains from his or her investments. Therefore, understanding inflation-adjusted or real returns is essential for all investors. Simply put, the real return is nominal return minus inflation.
For instance, while a bank savings account offers a nominal return of 2-4% per year, the actual return is negative since the average inflation rate over the past 12 months was 6% — far higher than the bank yield of 4%.
Now that we have that knowledge, let’s examine how inflation affects various asset classes.
- Fixed Income
Due to the inverse link between inflation and interest rates, fixed-income investments are most affected by inflation. As inflation inched upward, investors anticipated that returns would also increase to outpace inflation. However, because interest rates on debt instruments are fixed for the duration of their terms, the prices of these instruments fall when investors sell existing, lower-yielding goods and purchase those with greater yields. Thus, fixed-rate debt investments stand to lose the most in a rising inflation environment. Occasionally, RBI may use monetary policy and systemic liquidity to manipulate interest rates or yields on debt products. Inflation-Protected Securities are a type of bond whose rates are adjusted to account for inflation, which may be considered during periods of rising inflation. Similarly, Floating-rate bonds could be considered during periods of rising interest rates.
- Equity
In terms of stocks, inflation can be positive or negative depending on its amount, nature (transient or persistent), the external macro environment, sector exposure, balance sheet structure, and pricing power of each company. Low to moderate inflation between 2 and 6 percent is generally favorable for equities, whereas hyperinflation between 10 and 14 percent is detrimental. If competitive dynamics allow a company to raise the prices of its end products proportionally in response to rising raw material costs, it is said to have pricing power. In this scenario, the ultimate consumer bears the brunt of inflation, while the company preserves its profit margins. Such enterprises are rewarded by the capital markets, which results in increased stock prices. However, if demand is suppressed owing to weaker consumer mood, high unemployment, sector disruption, or any other reason, it will be difficult for companies to pass on the higher raw material price to the final product price. This would result in a decline in profits, which would affect stock prices.
- Commodities
Commodities are tangible, real assets and a strong inflation hedge since their prices define the underlying inflation. Their prices are indicative of future inflation. Inflation is a weighted measure of the prices of a basket of various goods and services, including raw materials (wholesale inflation) and end products (consumer price inflation). The proportion of these products is determined by government authorities in each country. Consequently, commodities (primary resources, metals, energy, agricultural products) tend to perform exceptionally well in an inflationary environment, and vice versa.
- Gold
Since gold is a valuable metal and a commodity, the same relationship applies to it as well. The finest inflation hedge is gold, which is sometimes referred to as a “premium store of value” since it tends to protect the value of your portfolio during periods of rising inflation. However, if central banks increase interest rates in response to inflationary pressure, non-yielding assets like gold may lose some of their appeal to some investors. Other characteristics of gold that make it a valuable strategic asset in investment portfolios include its ability to generate returns over long time horizons, great diversifier due to its low correlation with other asset classes in both expansionary and recessionary periods, and liquid as other traditional financial assets, with low credit risk. Investors also view gold as an “alternative currency” or “currency of last resort,”, particularly in nations where the value of the national currency is declining.
Best Investment Strategies To Beat Rising Inflation Rate
One of the best strategies to beat inflation is to invest in assets that have a higher likelihood of being equal to or higher than the rate of inflation tomorrow. When choosing the best investment products to fight inflation, investors should always perform extensive research on their risk profile and goals. It could become challenging to evaluate your risk tolerance and financial objectives. A Registered Investment Advisor can help you create financial goals and determine your risk tolerance.
One of the critical steps to keep in mind when making investments is diversification. Some investments, especially those that are equity-focused, may seem to offer extraordinarily high returns, but they also include a certain amount of risk. It’s crucial to diversify in accordance with your goals, level of risk tolerance, and anticipated inflation.
Let’s take a look at some investment opportunities in India to determine if they have historically outperformed inflation. Additionally, it’s crucial to keep in mind that past performance is not necessarily a reliable indicator of future performance.
- Investment In Equity Market
Historically, stock gains typically have beaten inflation rates in the long term. Taking into account the rising costs of goods and services might result in increased business earnings. Higher share prices are a result of better prices. Although this may not always be the case, traditionally the stock market has offered returns that have outperformed inflation.
Although there are numerous ups and downs and turbulent situations in the near term, stock markets have historically beaten inflation in the long run. The years 2021 and 2022 are one of the most appropriate instances. The Sensex had increased from about 25000 in October 2020 to 61000 in October 2021, currently, it is trading on 55000 plus points as of July 2022.
As of April 2022, Sensex has returned a CAGR of more than 15% during the previous five years. The performance of a single stock, however, may vary from that of a benchmark index.
This illustrates that markets eventually bounce back. Losses and risks are counterbalanced in the long run. You may combat inflation by making well-researched, goal-oriented stock market investments. We have listed down below some of the investments which one can consider in order to beat inflation.
- Equity Mutual Funds
For many investors, it can be challenging to track daily changes in the market or certain equities. After deciding which fund seems to be most suited to their particular needs and aspirations, and after consulting their financial adviser, they may invest in equities mutual funds. Equity funds come in a variety of subcategories that can accommodate different types of investors’ needs. There are a variety of equity funds available, including sectoral, market capitalization-based, investing strategy-based, tax-saving, and more.
Historically, index mutual funds tracking NIFTY and Sensex have consistently maintained 5- and 10-year returns above the inflation rate.
- Gold ETF
Gold ETFs are open-ended mutual fund schemes that give investors exposure to the gold market and are based on gold’s fluctuating prices. Physical gold does not generate income, and its costs of production and maintenance are significant. Gold ETFs are a good alternative for investors hoping to outperform inflation over the long term.
- REIT (Real Estate Investment Trust)
REITs are available to investors who find it difficult to invest in real estate because of its high capital requirements. Real estate investment trusts (REITs) are corporations that own and/or manage properties such as apartment complexes, office buildings, retail malls, and warehouses. They are a collection of real estate that pays investors dividends.
When inflation increases, property prices and rental revenue also increase. REITs perform well during periods of inflation due to their capacity to increase rents and then distribute the additional money to shareholders.
A downside of REITs is their vulnerability to the market for other high-yield assets. Treasury assets are typically more desirable as interest rates rise. This can divert capital away from REITs, hence decreasing their share prices. REITs must also pay property taxes, which is an additional expense.
- Inflation-Indexed Bond
Inflation-indexed bonds are among the safest and most efficient strategies to hedge against inflation. Inflation-indexed bonds are one of the numerous types of government bonds issued by the RBI. The principal amount of this bond is modified to reflect changes in inflation, and interest is paid on the adjusted principal.
The math is somewhat complex, but let’s examine an example to assist you comprehend it. Assume that the rate of inflation at the end of the year is 10%. You own a 100 rupee bond with an annual interest rate of eight percent. In the event of a standard bond, the interest at the end of the year would be Rs. 8, but in the case of an inflation-indexed bond, the principal would be updated to account for inflation, bringing it to Rs. 110, and 8% would be paid on this, Rs. 8.8.
- Debt Mutual Funds
Mutual funds investing in bonds and fixed income debt instruments constitute debt mutual funds. These investments are extremely liquid and pay a fixed rate of return. The interest rate is adjusted to reflect inflationary and interest rate fluctuations. Consequently, it is a feasible alternative for combating inflation.
Final Words
Inflation is a long-term socioeconomic process with ripple effects on individuals. Diverse market strategies have emerged to combat inflation. The primary causes of inflation are cost-push or demand-pull scenarios. It is entirely possible to outpace inflation, but it is also vital to regularly rebalance the portfolio and appropriately practice diversification to account for the current level of inflation and market volatility.
Disclaimer: This article serves only educational purposes. This should in no way be interpreted as a buy/sell recommendation. Before investing, please visit your investment advisor.
FAQ
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Is inflation bad for the economy?
In general, moderate inflation is viewed as a sign of a thriving economy, because as the economy expands, so does the demand for goods. As a result of this increase in demand, suppliers are compelled to produce more of the product or services that consumers and businesses desire. This economic expansion increases the demand for labor, which typically leads to wage increases.
This is the reason why RBI is mandated to control inflation between 2% to 6% as per CPI Index.
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What is hyperinflation?
Hyperinflation is the quick, excessive, and out-of-control rise in overall prices within an economy. Inflation is a measure of the rate at which prices for goods and services are rising, whereas hyperinflation is an inflation rate that often exceeds 50 percent per month.
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How does high inflation affect money?
Inflation erodes the average person’s purchasing power. It is one of the main factors that reduce the value of your money over time. It means that the money you have at the beginning of the year has a lesser value at the end of the year in terms of purchasing goods and services.
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