Inflation: All You Need To Know
Inflation is the first thing that all of us should know on the subject of wealth management. It is very surprising that most educated and learned persons /investors still do not fully comprehend the term Inflation and it's impact on us. Ronald Reagan, the 40th US President, once said that "Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man". There are a lot of things that we can learn about Inflation and things related to it. In this piece, we attempt to present a simple FAQ on the subject.
What Is Inflation?
Inflation in simple terms means general price rise of goods & services. In economics, Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services. In other words, the real purchasing power of currency reduces due to Inflation. As Sam Ewing once said "Inflation is when you pay fifteen dollars for a ten-dollar haircut you used to get for five dollars when you had hair".
How Is Inflation Measured?
Inflation is usually measured based on certain indices and broadly, there are two categories of indices for measuring Inflation i.e. Wholesale Prices and Consumer Prices. For measurement, an index number or a single fi gure is arrived at that shows how the related basket of goods & services has changed over time. Thus we have the Consumer Price Index (CPI) and the Wholesale Price Index (WPI) as the two major indicators of Inflation. The Inflation rate is the annualised percentage change in the index over time.
CPI (also retail Inflation) = Measures changes in the price level of a market basket of consumer goods and services purchased by households. It is the Inflation which is borne by us as individuals.
WPI (also headline Inflation) = Measures changes in the price level of a representative basket of wholesale goods which are traded by producers. It is the Inflation at the level of producers and has more meaning to industries & manufacturers. It is measured more quickly than CPI which takes more time to get reflected in the index. Different countries have different methods of measuring Inflation. In India, like many other developing countries, uses the Consumer Price Index (CPI) as it's central measure of Inflation. Previously India used Wholesale Price Index (WPI) as the measure for Inflation but since year 2014, the new CPI (combined) is the new standard.
What Are The Reasons For Inflation?
There are several factors that affect Inflation in an economy and it is not easy to identify the exact relationship between different factors and it's impact on Inflation. For the sake of simplicity, we will broadly take a look at the primary factors for Inflation here...
Demand factors: It happens when the aggregate demand exceeds the aggregate supply. It is a situation where too much money chases few goods. Increased money supply due to loose monetary policy and low interest rates results in Inflation. Fiscal deficit financing by government by way of printing more money also results in Inflation.
Supply factors: It happens when the aggregate supply is not able to meet the aggregate demand. It is a cause of Inflation in an agrarian country like India where food is a major component of CPI. Further, because of rising wages & cost of capital also impacts the production cost of goods & services leading to rise in prices.
Domestic factors: In addition to demand & supply, the quantum of spending by government in the economy directly a ffects Inflation. Further, higher employment levels, taxation rates, etc. also add to Inflation. Issues like hoarding, blockages, etc. also positively impact Inflation.
External factors: There are external factors like currency exchange rates, trade barriers, etc. which a ffect the price of imported goods. Commodity prices in international markets like crude oil, gold, etc. also has impact on domestic Inflation.
How Does It Affect Us?
Inflation affects us directly and indirectly and has both positive and negative impact on us. While we may not list every type of impact, here are a few ways in which we may get affected as investors.
Purchasing power: Inflation hurts our buying power since we will have to pay more for same goods & services. Thus, with an Inflation of say 8%, your 1 lakh rupee today will be worth only R46,319/- in ten years time.
Cost of living: The cost of living is not equal to Inflation but is an aggregate impact of Inflation in our day-to-day lives. With Inflation, our general cost of living will increase and unless we are o set by rising income by the same rate, we will have increased expenditure and reduced savings. It will mean that one financial goal today will be worth lot more in future. For eg., when planning for retirement after say 25 years, your 50,000 worth of monthly expenses would rise to over 3.42 lakh rupees at an Inflation of 8%.
Wealth Creation: If your investments are not earning you more than Inflation then you are not actually growing or creating wealth. To create wealth you need to generate more of 'real returns' which we will talk later.
Interest rates: In case of sustained periods of high Inflation, the government is likely to keep interest rates higher meaning that loans will be at higher rates while rates of deposits will be also kept higher to absorb money. There will be less of government spending in general. In periods of low Inflation, interest rates will subsequently fall and this may also lead to a fall in interest rates offered by small savings /deposits making it a challenge in retirement planning.
Housing & stocks: In general, if you have already have investments in housing /stocks/equity mutual funds before Inflation, you will be in position to benefit from Inflation when prices rise. However, if not, you will find them expensive to buy later.
What Are Real Returns?
As investors, we should always look at returns not as notional returns but as real returns. Notional or stated returns is what you receive but real returns is what you are getting in real terms – after removing Inflation. For eg., if a bank account is giving you 8% pre-tax returns yearly – even with conservative retail (CPI) Inflation of say 7%, you are only getting 1% returns. If you consider post-tax (30% slab) returns of 5.6%, then your real returns are a negative of 1.4% meaning that you are loosing money by investing in such an avenue.
Next time whenever you are evaluating investment decisions, please remember real returns. Going a step further, it will be great if we calculate post-tax, real returns between investment avenues /products for our investment horizon.
How To Get Protection Against Inflation?
First, be aware of the Inflation figures and their impact in future costs. But merely knowing Inflation and real returns is not enough and we must also act to get protection against Inflation. Here are a few things that we should do in order to get protection...
Do Goal planning: Inflation is at the heart of financial planning. You must get to know your future financial needs to fulfill your life goals/dreams with the 'right' Inflation figure. The right Inflation rate is critical since CPI cannot be applied in general to all financial goals. For eg., Inflation for education and medical treatments is observed to be over 10%.
Save & invest aggressively: Merely planning is not enough and you also would need to aggressively save money and invest money. This means reducing expenses and controlling your budget.
Get Real Returns: Investments have to be made in asset classes /products giving you the maximum post-tax "real returns" as per your risk profile. The case is strongly in favour of equity asset class which has no long term capital gains (over 1 year) and where long term returns (at least 5 years) potential is the highest (average 12-15% expected) among all asset classes. This means that even at 12% nominal returns you are getting 5% of real returns vs. 1.4% of negative returns in fixed income instruments with 8% pre-tax returns.
Conclusion:
As Milton Friedman once said, "in¬flation is taxation without legislation". And there is no escaping it and no magic wand to keep it tamed and friendly for you. Infl¬ation impacts our financial lives more than anything else and we have to understand how infl¬ation would impact our future finances and financial goals. Understanding though is only the first step and protection is the next step where we must learn to interpret figures in terms of real returns and aim to maximum same. Unless we do not start doing that, we will keep eroding and loosing the our wealth without even knowing.
