Are you feeling it?!?

Mukesh Ambani calls an emergency family meet at the terrace of his home, to discuss the havoc inflation was causing to family finances. Ten minutes past the scheduled time & no sign yet of Nita Ambani! It was to a cold reception that she finally arrived. Really, was she to blame if the other 4 family members beat her to the 4 home lifts. The damned lift was no bullet train & with 27 floors down & then up – the late arrival was inevitable to say the least.  

No! this is no reality programme on Ambani family. Rather, it was a dream that I had last night!!! I am not sure if the Ambani clan has ever been to their home terrace but imagining Ambani(s) scurrying around, worrying about inflation, does seem a bit funny. Can you imagine any of the top 10% rich, breaking a sweat now that world is experiencing 4-decade high inflation?!? No, luxury goods will continue to sell well even as line for free food keeps getting longer. It is different point in time for everybody when the pinch begins to be felt.

Well! Are you feeling it yet?!?

The importance of understanding the various dimensions of this phenomenon cannot be overstated. Be assured, you would be thinking a lot on this topic over near future, even if not already doing so.

(*** Brief detail on various aspects of inflation follows this article.)

Unequal Impact of Inflation

The effect of inflation – loss of purchasing power – is common to each one of us but its impact is very much unequal. Differences in spending pattern & varying degree of inflation in different goods & services – lead to unequal levels of inflation for different households. Inflation inequality is the unequal effect of inflation on middle, upper-class people & lower-class people.

Cost of living increase can be attributed to the nature of composition of consumption basket. It could be

  • health care expenditures for the elderly,
  • food & gasoline prices for the poor households,
  • education & health care for the middle class.

The disparity in impact of inflation on different sections of economy cause the income gaps between rich & poor to widen. The main reason of the unequal impact lies in the type of work that generates income, which in turn determines the time-lag & degree to which inflation gets adjusted to a person’s revenue source.

  • Lower-income people have much less negotiating power because of power imbalance. When prices rise, wage for such individuals tends to stay stagnant for a while. As a result, their purchasing power plummets.
  • Goods & services with administered prices, are only able to pass on price increase to the consumer, with a certain time lag such as agricultural produce etc.
  • Better quality job people tend to have inflation-adjusted benefits. When inflation occurs, these benefits mitigate the negative inflationary impact.
  • Businesses tend to pass on inflationary impact to its customers in real time & if it finds itself unable to do so, reduces its size/cost to remain profitable.
  • Equity investment income is a proxy of businesses in formal sector & of certain scale. Business profits have to keep pace with inflation to remain viable & such growth in profits gets reflected in better valuation of equity shares. Thus, money invested in equity shares maintains / improves its purchasing power.

Inflation Data

Check out the inflation data over last 10 years. The average cost of basket of goods has increased 67% by government estimates & must actually be much higher at household level. Effectively, by year 2032, you would need double the money you have now, just to maintain your living standards – assuming – your consumption basket & inflation rates remain same.

Please note that need for income (plus savings – which is postponed consumption) is going to be even steeper because

  • Both assumptions are totally unrealistic. Just reflect on how much the basics of living have changed in last ten years. The changes will come even faster in future. Secondly, inflation in a growing economy is a given. Expect even higher rates, just so that you are not blind-sided if it so happens.
  • Downside of not maintaining purchasing power, is reduced living standards.   

All India Inflation rates (on Point-to-Point basis – current month over same month of last year – March 2022 over March 2021), based on General Indices & CFPIs (Consumer Food Price Index) are given as follows:

All India Inflation rates (%) based on CPI (General) & CFPI
IndicesMarch 2022 (Prov.)
CPI (General)                                         6.95%
CFPI                                                         7.68%
All India Consumer Price Index – March 2022 Index (Prov.) (Base: 2012=100)
Main HeadCombined (Rural & Urban)
Food & Beverages                                                            168.4
Cereals and products                                                        151.2
Meat and fish                                                                    210.7
Egg                                                                                    167.8
Milk and products                                                           162.2
Oils and fats                                                                    194.7
Fruits                                                                                 157.6
Vegetables                                                                      166.9
Pulses and products                                                          163.9
Sugar and Confectionery                                                   118.8
Spices                                                                                174.2
Non-alcoholic beverages                                                  177.4
Prepared meals, snacks, sweets etc.                                   179.3
Pan, tobacco & intoxicants                                         193.7
Clothing & footwear171.1
Clothing 172.1
Footwear   164.6
Housing 165.3
Fuel and light                                                                     167.2
Miscellaneous     164.6
Household goods and services162.8
Health173
Transport and communication157.9
Recreation and amusement163.3
Education165.9
Personal care and effects                                                      167.2
General Index (All Groups)                                              167.7
Consumer Food Price (CFPI)                                166.9

***Brief Explanation

Inflation

Inflation is a broad measure of increase in prices or cost of living over a given period of time.

  • The absolute value of a currency note, say Rs. 100/-, remains constant over time.
  • When prices of goods & services increase, household income (received in such constant value) can afford to purchase less.  In other words, purchasing power of income falls.
  • Real income (inflation-adjusted income) is a proxy for the standard of living. When real incomes rise, standard of living is deemed to improve.

Measuring Inflation

At Individual Level The cost of living depends on prices of goods & services consumed & the share of each in the household budget. The change in cost of living is inflation for the household, assuming living standard remains same. The average calculated for total population (rural, urban or consolidated), may differ from inflation of a household’s basket.

At Consumer Level – The average consumer’s cost of living is measured by household surveys that identify a basket of commonly purchased items & tracking over time the cost of purchasing such basket. The measure is called Consumer Price Index (CPI) that expresses cost of this basket at a given time relative to a base year.

Core Consumer Inflation – It identifies underlying & persistent trends in inflation by excluding prices set by the government & which are affected by seasonal factors.

At Country Level – The index at country level has broader coverage & the calculation includes GDP deflator. The contents of GDP deflator are more current, including non-consumer items (such as military spending) & vary each year (CPI basket is mostly fixed). It is not a good measure of the cost of living, as such.

What Creates Inflation

Money Supply – Quantity theory of money explains inflation in terms of relationship between money supply & size of economy. Inherent value of currency will decline if money supply grows faster than the size of economy.

Cost Push – Increase in cost of items with inelastic demand such as fuel & food, transmits cost-push inflation through the entire system by trade. Impetus for price increase may come from supply side i.e., disruption in supply chain of inputs. Such disruption may be due to

  • natural disasters or
  • man-made crisis such as war, cartel pricing etc.

Demand Pull – Impetus of price increase may also come from creation of extra demand (GDP growth) vis-à-vis production capacity of an economy, by

  • decrease in interest rate by central banks,
  • increase in government spending (increase fiscal deficit),
  • stock market rally (wealth effect)

Expectation of Inflation – Expecting price increase in future causes ‘next-period inflation’. Such expectation finds reflection in – consumer buying more than requirement, wage negotiations, contractual price adjustments, automatic rent increase etc. Since human behavior is guided by recent experience, the pattern of ‘expectation causing next-period-inflation’ forms a loop & continues for some time.

Cost of Inflation

Erosion of Real Income – Prices in the economy change at different paces. Regularly traded commodities get priced immediately while other factors in economy get adjusted at periodical intervals such as wages. This uneven change causes loss of purchasing power for those with less negotiating power.

Fixed Interest Rates – Purchasing power of fixed interest rate products changes for the receiver as well as payer. If such fixed interest rate on debt is less than inflation rate then

  • purchasing power of payer improves, provided his income maintains pace with inflation.
  • real income of lender suffers.
  • purchasing power of person dependent on fixed interest income (say, a retiree) continuously declines.

Less Valuable Currency Countries facing hyper-inflation or high inflation rates have to devalue their currency & are faced with increased transactional costs.

Central Bankers & Inflation Targeting

Central Bankers have a love-hate relationship with inflation. Consumer behavior, types of goods & services produced, strength of currency, foreign trade & GDP growth rate are all deeply intertwined with inflationary trends in the economy.  Central bankers recognize the critical role of inflation in orderly conduct of economy & therefore target an inflation rate, that can balance the demands of various constituents.

Low, Stable, & Predictable inflation is good for an economy. The distortionary impact of inflation is reduced if it is low & predictable, as that causes least volatility in the economic environment. A steady pace of price increase gives consumers an incentive to make purchase sooner boosting economic activity, producers are more confident planning for growth & interest rates do not regular tweaking. Uncertainty on any account adds risk premium to the mix.

Deflation, or falling prices, is not desirable because when prices are falling, consumers delay making purchases, anticipating lower prices in the future. That sets off a chain reaction of less economic activity, less income generation by producers & lower economic growth for economy as a whole.

Central Banker’s Policy Arsenal include

  • interest rate at which debt flows in the economy,
  • administrative price setting of goods & services &
  • fixing exchange rate of currency.

The aim is to guide household & production decisions in the desired direction of either contracting or expanding the aggregate demand in the economy, managing inflationary expectations & providing predictable environment for long term contracts.  

How do Inflation & Investment influence each other?

Macro Level Inflation rate is a key input in determination of interest rates & money supply. Higher interest rates mitigate the loss of purchasing power due to inflation but would adversely impact capital investment & productive capacity in the economy. The economic policies have to carefully navigate through ‘interest rate-demand’ maze because controlling inflation & protecting economic growth require opposing policy interventions.

Household Level Loss of purchasing power due to inflation & the rate at which happens, has significant bearing on spending, saving & investment decisions.

Fixed Return Investment –

  • Held to Maturity returns – Real returns would be net of inflation. Bank FD are giving negative returns at the moment with interest rate significantly less than inflation rate.
  • Marked to Market returns – Price of fixed income security is inversely related to interest rate. In high inflation scenario, when interest rate is increased, market price of security will fall. Longer the duration till maturity, greater will be the negative impact on price of security when interest rates rise.  

Equity Investment The relationship between inflation & equity investment performance, is less definite. It would build in the influence of other factors such as

  • Products with inelastic demand benefit as inflation is passed on to consumer & become more attractive in the investment basket.
  • High & persistent inflation reduce aggregate demand if incomes fail to catch up & if real incomes do not decline, consumers save more & postpone buying decisions on account of uncertain future. Also, increase in interest rate feeds into higher production cost loop, impacting profitability in process.
  • Equity prices may initially get a boost with increase in profits when inflation gets passed on to consumer but get negatively impacted when growth prospects start getting shaky.

Real EstateCurrency loses its value (purchasing power) with inflation. In high inflation scenario, where confidence in financial asset is shaken, physical assets could prove to be good hedge against inflation & be preferable as an investment. Real estate investment trusts (REITs) can provide access to real estate investments with reasonable ticket size, with possibility of interest & dividends as regular distributions.

Commodities Gold has proven to be good hedge in times of high inflation & uncertainty. Exchange Traded Funds (ETFs) & sovereign gold bonds (annual coupon + capital gain/loss) provide an easy access for retail investors to include this asset class in portfolio.

How to hedge Investment against Inflation?

Hedging investment against inflation implies protection against ill-effects of inflation. Key factors that help maintain purchasing power of investment are

  • Backing of real (physical) assets such as Gold ETF, REIT etc.
  • Inelastic demand of product sold by business
  • Under-valuation of equity after taking into account challenges on profitability & growth
  • Equity of business enjoying leadership position, competitive advantage & better technology, human resources & management.

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