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Inflation
Defining Inflation
Inflation is an economic concept. Inflation basically means the rise in price of
goods and services. Since price rise affects each and every individual and can
drastically affect lives.

Type of Inflation
There are basically two main types of Inflation.
- Cost-push Inflation
- Demand Inflation (or Supply demand mismatch)

Cost-push Inflation: It is defined as persistently rising general price levels,

brought about by rising input costs. In general, there are three factors that
could contribute to cost-push inflation: rising wages, increase in corporate
taxes and imported inflation (when imported raw or partly-finished goods
become more expensive, often as a result of currency depreciation). For
inflation to be cost-push in nature, increases in input prices must affect a large
proportion of the country’s producers, so as to be able to push up the general
price level.

In history, an ideal example of cost-push inflation would be the oil crisis of the
1970s, which some economists see as a classic example of imported inflation
experienced in the Western world in that decade wherein price increases of a
key imported constituent impacted the price of goods across industries.

Demand pull Inflation: Demand-pull inflation arises when the aggregate

demand in an economy outpaces aggregate supply. This is commonly
described as “Too much money chasing too few goods”. With increasing per
capita income seen in emerging economies, this aggregate demand for goods
and services has been increasing.

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How is Inflation measured?

Consumer Price Index (CPI): The CPI is a measure of the price of a set pf
goods and services. The “Bundle,” as the group is known, contains items such
as food, clothing, edible oils etc. The amount of inflation is measured by the
change in the cost of the bundle: if it costs 5% more to purchase the bundle
this year as compared to last year, we could say inflation has been 5% based
on CPI.
Wholesale Price Index (WPI): While the CPI indicated the change in the
purchasing power of consumer, the WPI is a measure of change in the prices
changed to intermediaries. The WPI measure the price at which a good is sold
to other business before the good is sold to a consumer. The WPI actually
combines a series of smaller indices that cross many industries and measure
the prices of three types of goods, crude, intermediate and finished.

Generally the markets are most concerned with the finished goods because
these are a strong indicator of what happen with future CPI reports. Though
the CPI is a more popular measure of inflation than the WPI, investors watch
both closely. The weekly inflation numbers that are released are based on
WPI.
Inflation Baskets
CPI WPI
Food, Beverages & Tobacco Electricity for Railway Traction,
Cereals, Pulses, Oil & fats, Meat, Fish etc. Purified Terephthalic Acid (PTA)
Milk & Milk Products Injection Moulded Plastic Items
Condiment, Spices etc. Oxygen Gas in Cylinders
Vegetables, Fruits Railway Sleepers (Cement Product)
Sugar, Honey etc. Thinner
Non-Alc Beverages MS/SS Ingots
Prep. Meals etc. Cold Rolled Sheets
Pan, Supari, Tobacco etc. LPG Cylinder
Fuel & Light Jelly Filled Telephone Cables
Housing Color TV Sets
Clothing, Bedding & Foot-Wear etc. Computer &Computer based Systems
Miscellaneous Light Products
Medical Care Power, Lubricants….etc
Education Total 453 items
Recreation & Amusement
Transport & Communication
Personal Care & Effect
Household Requisites & Others….etc

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Rate of Inflation
The rate of inflation is important as it represents the rate at which the real
value of an investment is eroded and the loss in spending power over time. In
other word the rate at which the prices of everything go up is called the “rate
of Inflation”.

It is crucial to include measure of expected inflation when calculating your

expected return on investment.
For example, if the price of something is Rs.100 this year and next year the
price becomes approximately Rs.104 then the rate of inflation is 4%. If the
price of something is Rs.80 then after a year with a rate of inflation of 4% the
price go up to (80 x 1.04) = 83.2

So, when you make an investment, make sure that your rate of return on the
investment is higher than the rate of inflation in your country. In our county
India, for the year 2005-2006 the rate of inflation was 4% (Which is really low
and amazing!). This rate keeps changing every year. The finance minister
generally gives the official statement on the inflation rate of the country for a
particular year.

Second example is if your family's monthly expense is Rs.50,000. At an

inflation rate of 5 per cent, how much will I need 20 years hence with the
same expenses?

The required amount can be calculated using the standard future value
formula. Inflation means that over a period of time, you need more money to
fund the same expense.

Formula: Required amt. = Present amt. *(1+inflation) ^no. of years

Type in: = 50000*(1+5% or .05) ^ 20 and hit enter. You will get Rs.1,32,664
as the answer, which is the required amount.

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What is the rate of return?

The rate of return is how much you make on an investment. Suppose you
invest Rs.100 in the market and over a year, you make Rs.120, then you rate
of return is 20%.

If you invest Rs.100 in the market today and you make money at a 3% "rate of
return" in one year you will have Rs.103. But now, since the rate of inflation
is at 4%, an item costing Rs.100 today will cost Rs.104 a year from now. So
what you can buy with today’s Rs.100, you will only be able to buy with
Rs.104 a year from now.

But the Rs.100 that you invested has grown only at a 3% rate of return and so
it is worth Rs.103. In effect, you are loosing money!

Second example is if you invest Rs.1000 in a 1-year FD that will return 5%

over that year, you will be giving up Rs.1000 right now for Rs.1050 in 1 year.
If over the course of that year, the inflation is 6% the purchasing power of Rs.
1000 has decreased by Rs.60, and you have actually made a loss of 1%.

What it means that if you had spent that Rs.1000 instead of investing, it you
would have been able to purchase a larger bundle of goods than was possible
with the Rs.1050 you earned a year later. However, this is not a suggestion
that you spend your money instead of saving it. This only highlights the fact
that your investment decision should account for the expected inflation. The
rate which one arrives at after taking inflation into account is known as the
real rate of return.

This real rate of return = Rate of expected returns – Rate of expected inflation.

So in conclusion, the rate of return on your investments, have to be higher

than the rate of inflation.

The inflation rate is measured every week and announced on Thursday. Most
news publications report them on every Friday.

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Hedging against Inflation

• Review your emergency fund requirement. Keep six months' expenses
as emergency funds, mostly in short-term debt funds such as inflation- and
tax-efficient FMPs.
• Examine your health and life cover. With costs going up, you need to
bump up your life and health covers. Go for low-cost, high-cover term
plans and floating health covers to bridge the gap. Avoid large idle savings
and bank balances. Invest in short-term debt funds like FMPs.
• Defer large loan-based purchases. Avoid large EMIs that will stretch
your finances more. Go for your first home if you can afford the down
payment and EMI.
• Prepay high-cost loans. Start with your floating rate home loan.
Remember, no investment option will provide guaranteed returns that
equal the higher interest payout.
• Seek capital gains and dividend instead of interest. Interest income gets
taxed at your income tax rate. Long-term capital gains and dividends from
equity and equity MFs are tax-free, but taxed at 10 per cent without
indexation and 20 per cent with indexation if coming from debt funds.
Dividends from debt funds are tax-free post dividend distribution tax.
• Continue staggered investments in equity and equity MFs. Carry on
with your systematic investment plans (SIPs) in equity funds. For fresh
investments, seek large-cap funds from OLM 50 that are likely to benefit
from a rebound along with blue chips they predominantly invest in.
• Diversify into international funds and gold. Gain from the upsides in
well-performing equity markets in other countries by investing in
international funds. Investing in gold (up to 5-10 per cent of your corpus)
will give your portfolio a stable growth.
• Avoid interest rate-sensitive stocks. This includes sectors such as real
estate and auto. The best bets would be large-cap Pharma and FMCG
stocks currently available at attractive valuations.

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