Updated: Oct 30, 2020
Get to know about the underlying and the intangible reason for price hikes in a country which impacts a million aspects, Inflation
What is Inflation?
Inflation refers to the price hike in purchasable commodities and assets of a country such as groceries, consumable products, machinery, etc. Inflation guesstimates the average price change of commodities and frameworks calculation for a specified time horizon. Rarely, some countries follow a negative inflation rate called Deflation. Inflation in a country majorly occurs when an individual spends a lot from his hands or the rise in demand for commodities. Sudden price hikes of petrol and commodities like onion can be a good case in point for Inflation.
How Inflation is measured?
The conceptual idea of Inflation is measured using two main economic factors of a country :
Wholesale Price Index (WPI)
Commodity Price Index (CPI)
These two divisions deal with the price change in commodities and sales driven by enterprises. To specify, WPI can be portrayed as wholesale goods purchased from large enterprises to smaller firms for further distribution.
Secondly, CPI can be quantified as the price change in various commodities and services purchased by households or individuals of a country such as food, groceries, educational services, consultancy services, etc. CPI also provides understandings of how much an individual can spend his money on commodities with respect to price change.
These major divisions contribute to the supply chain of a country and help in measuring the Inflation rate. Financial institutions and central banks give utmost importance to CPI rather than WPI for measuring the inflation rate of a country.
Who controls inflation in India and how?
In India, Inflation is controlled and supervised by the Reserve Bank of India (RBI). To contain inflation, RBI uses a tool called 'Repo Rate'. If a bank went a shortage of funds, it requests RBI for money lending. RBI lends money to banks at a specified rate called Repo Rate. When a country's inflation gets hyped, RBI increases the repo rate to reduce lending of money for banks, resulting in paring of the money supply. If the money supply in a country is declined, the inflation rate automatically stabilizes. At the occurrence of the repo rate, the deposit rates of commercial banks also increase, incentivizing people to hold their money in the bank repository.
On the contrary, when banks hold an excessive amount of funds, RBI initiates another tool called 'Reverse Repo Rate (opposite of Repo Rate)'. Reverse Repo Rate is a monetary policy in which, RBI themselves borrow money from commercial banks to manage liquidity in the economy. In India, RBI primarily uses Repo Rate as a crucial element in managing the inflation rate.
Correlating Repo rate, Reverse repo rate with Inflation
When correlating the measures with inflation, we can get a clear picture of what RBI tries to do with repo rates against inflation. Starting with the year 2000, the inflation rate was compressed to 4% as the repo rates stood high at that time with 8%. Throughout the time series chart, we can catch the sight of reverse repo rates moving along with repo rates. Later on, the inflation rate gradually increased to 4.30% in the midst of 2000-2005 with respect to declining in repo rates. After the following years of 2005, India witnessed the highest inflation rate which reached 11.9%. This was because of the diminishing repo rates over the years from 7.75% to 4.75%. Post-2010, the repo rates reversed the trend to project a steady increase from 4.75% to 8.60% which resulted in a complete downtrend in the inflation rate. Between the years 2015 and 2018, the repo rates stood as a defensive wall, led inflation which saw an ever-low percentage of 2.49%. At present, RBI constrained the inflation rate to 5.84% and regulated the repo rates at a percentage of 4%. Thus, The Reserve Bank uses repo rates and reverse repo rates optimistically and helps India to withstand its inflation rate.
What are the effects of Inflation?
1. Reduces Purchasing Power
One of the devastating effects of Inflation is the reduction in purchasing power. At the time of inflation, goods and commodities sell at exorbitant prices which leaves people short of purchasing power. The above chart which illustrates the twenty-year period of India is an example of how the purchasing power of people diminished in the long run. According to the chart, if a man had bought a commodity by paying one lakh rupees in 2000, after years, to buy the same commodity at present he has to pay around 3.65 lakh rupees. Corresponding to the decline in purchasing power, the living expenses increase.
2. Reduces Value of Money
The impact of depreciation in the value of money is huge in the case of inflation. From the above illustration, if a man has retained one lakh rupees in 2000 without investing his money, the value at present is slumped to 24,000 rupees because it lost the value with an increase in inflation.
3. Reduces Return on Investment (ROI)
This chart depicts the ROI in various schemes by the government with respect to inflation.
Return on Savings Account :
If you invested one lakh rupees in a savings account in 2000, the deposited value would become 2.4 lakh rupees in 2020 as the interest rates keep ascending. But still, it won't suffice the inflation-adjusted value. By the end of 2020, the inflation-adjusted value of the same one lakh rupees is 3.65 lakhs rupees. Thus, return on a savings account is reported at a negative value of 1.18 lakhs rupees and a negative return per year of 5.46%, that is, an ROI of -118.24% in accordance with the inflation-adjusted value.
Return on Fixed Deposit (FD) Account :
The maturity value of an FD account, at present, is 3.76 lakhs rupees for the invested value of one lakh rupees in 2000 with a 0.53% return per year. But still, it's just a small return when compared to the escalated cost of living. Henceforth, the return on the FD account is 11,214 rupees additional to the cost of living and has a comparatively good ROI of 11.21% to the savings account.
Return on Public Provident Fund (PPF) Account :
The investment outlook of the PPF account is a boom among all as it exceeds the inflation-adjusted value with an absolute visible growth. The augmented value of the corresponding one lakh rupees invested in 2000 is 5.59 lakh rupees by the year 2020 with an annual return of 9.24%. We can say that investing our money in the PPF account will be an optimistic decision as it has an exceptional ROI of 194.14%. But, according to this scheme, a person can invest a maximum amount of 1.5 lakhs per year and this is considered as a limiting factor of the scheme.
Hedge your Investments from Inflation
Considering the above investment schemes, the yield and ROI is relatively less than the portfolio outlook of Nifty 50 (benchmark of 50 Indian largest companies stocks) over the time horizon.
According to this bar chart, if a person invested one lakh rupees in Nifty 50 right from the beginning of 2000, his growth value as of 2020 is 7.87 lakh rupees with a colossal Return on Yield of 787.50% and an annual return of 38%.
When comparing the preceding investment schemes, the difference between the inflation rate and growth rate projected inequality. Whereas, the growth value of Nifty 50 with inflation-adjusted value is 4.21 lakhs rupees yielding a return of 422% with an annual return of 20%. In general, the saying of getting an average yield of 15% from the stock market is proved by Nifty 50 by attaining more than average yield i.e., 20%.
Conclusion : Diversified Portfolio
However, holding only the stock investment will lead to tremendous trouble, even losing all the invested amount. For example, during the year of the Subprime Crisis (2008), the whole Nifty index declined by almost 52% i.e., from 6138 to 2959, and took around four years for its recovery. If a person had invested only in the stock market at this time, his investment portfolio would be null and void.
Then what's the solution? To get rid of these severe traumas, we need to deploy a conceptual idea called 'Diversification'. It is the process of splitting our investment portfolio outlook into various sectors and stocks. To frame a diversified portfolio, we need to understand two key aspects, 'Risk Aversion' and 'Time Horizon'. Risk aversion is the behavior of people willing to take risks and Time Horizon is the duration of our investment. So, in diversification, people have to choose their own comfortable risk percentage and time horizon.
Based on your customized framework on Risk Aversion and Time Horizon, you need to stick to the proportions of diversification, considering all the fixed income we discussed previously. Let's say, you can have your investment portfolio diversifying 50% in stocks, 20% in PPF, 20% in FD, and 10% in Savings account.
Hence, follow your instinct, create your investment strategy, build your optimal portfolio, maintain the principles of diversification, and zoom your investment outlook!