Inflation - Alarming heights and the hedging techniques on investments


Ms. Navya V
Faculty Member (Finance)

Everyone has `inflation' on their lips but it is worth looking at what exactly inflation is, and how it arises. Inflation pared down to the essentials means a rise in an index consisting of many goods that have weights attached to them. The index always has a base year. If a particular item has a higher weight and its price rises, it will have a greater effect on the inflation rate. At the end of the day it depends on how much weight a particular item is assigned. Most countries use a consumer price index (CPI) while India has a wholesale price index (WPI). As their names suggest, the CPI pertains to a set of items that a consumer consumes while the WPI is a basket particular to the wholesale market. Therefore, if the inflation for a particular week is, say, 10 per cent, it means the index is 10 per cent higher than it was the same week the previous year. Then there is core-inflation, which means the inflation rate without taking into account food and fuel.

Milton Friedman once said: "Inflation is always and everywhere a monetary phenomenon." What exactly does that mean? It essentially means that inflation is always caused because of too much money in the system. In other words, inflation in a country is always caused because the supply of money is much greater than the demand for it.

Causes Of Inflation

There are a few different reasons that can account for the inflation in our goods and services; the following are a few of them.

  • Demand-pull inflation refers to the idea that the economy actual demands more goods and services than available. This shortage of supply enables sellers to raise prices until an equilibrium is put in place between supply and demand.
  • The cost-push theory , also known as "supply shock inflation", suggests that shortages or shocks to the available supply of a certain good or product will cause a ripple effect through the economy by raising prices through the supply chain from the producer to the consumer. You can readily see this in oil markets. When OPEC reduces oil supply, prices are artificially driven up and result in higher prices at the pump.
  • Money supply plays a large role in inflationary pressure as well. Monetarist economists believe that if the  Federal Reserve does not control the money supply adequately, it may actually grow at a rate faster than that of the potential output in the economy, or real GDP. The belief is that this will drive up prices and hence, inflation. Low interest rates correspond with a high levels of money supply and allow for more investment in big business and new ideas which eventually leads to unsustainable levels of inflation as cheap money is available. The credit crisis of 2007 (US) is a very good example of this at work.
  • Inflation can artificially be created through a circular increase in wage earners demands and then the subsequent increase in producer costs which will drive up the prices of their goods and services. This will then translate back into higher prices for the wage earners or consumers. As demands go higher from each side, inflation will continue to rise.

Effects of Inflation

The effects of inflation can be brutal for the elderly who are looking to retire on a fixed income. The money that they expect to retire with will be worth less and less as time goes on and inflation goes higher.

When the balance between supply and demand spirals out of control, buyers will change their spending habits as they meet their purchasing thresholds and producers will suffer and be forced to cut output. This can be readily tied to higher unemployment rates. When extremes arise in the supply/demand structure, imbalances are created.

The point that is being made is that if inflation is not contained and rises at an unsustainable rate; the stronger the impact on the other side. There is a saying; "the bigger they are, the harder they fall".

How to Limit the Effects of Inflation on Your Savings

The money that is not earning interest is exposed to inflation. Inflation can and usually does rise every year. For instance, 1% or even 3% rise in inflation can occur and does occur from time to time. This is the reason that prices go up and a rupee in 1970 bought much more than it does today. By saving money that doesn't earn interest, you are possibly losing several percentage points of its value each year.

In order to fight the effects of inflation, any money that you save should be invested. When you invest money, you earn interest. While no investment is 100% secure, saving money in a savings account, certificate of deposit or investing it in the stock market for the most part will grow your money. The more secure the investment, the lower the growth, but also the lower the risk.

In order to beat inflation, choose financial tools that will more than likely beat the effects of inflations such as a certificate of deposit, bonds, money market, etc. Another important tip to beat inflation year after year is to choose investments where the interest rate is not fixed or where money can be easily turned into liquid and invested elsewhere. For instance, investing in stocks is usually a good choice due to the fact that a stock is not limited in its growth, where a bank account has a fixed rate of return. If there is a jump in inflation, over the amount of your fixed interest rate, you will actually be losing money. But , the main problem with stocks and inflation is that a company's returns tend to be overstated. In times of high inflation, a company may look like it's prospering, when really inflation is the reason behind the growth. When analyzing financial statements, it's also important to remember that inflation can wreak havoc on earnings depending on what technique the company is using to value inventory.

Fixed-income investors are the hardest hit by inflation. Suppose that a year ago you invested Rs1,000 in a Treasury bill with a 10% yield. Now that you are about to collect the Rs1,100 owed to you, is your Rs100 (10%) return real? Of course not! Assuming inflation was positive for the year, your purchasing power has fallen and, therefore, so has your real return. We have to take into account the chunk inflation has taken out of your return. If inflation was 4%, then your return is really 6%.

This example highlights the difference between nominal interest rates and real interest rates. The nominal interest rate is the growth rate of your money, while the real interest rate is the growth of your purchasing power. In other words, the real rate of interest is the nominal rate reduced by the rate of inflation. In our example, the nominal rate is 10% and the real rate is 6% (10% - 4% = 6%).

Inflation-Indexed Bonds

There are securities that offer investors the guarantee that returns will not be eaten up by inflation. Treasury inflation-protected securities (TIPS), are a special type of Treasury note or bond. TIPS are like any other Treasury, except that the principal and coupon payments are tied to the CPI and increase to compensate for any inflation.

Inflation crossing 8% already and reports say will hit 9-10% soon. In other words, bad news for investments. Increasing inflation affects your purchasing power and can deal a body blow to your financial goals. Here's how you can inflation proof your investments.

  • Gold : Gold is the traditional hedge against inflation since the price of gold goes up as inflation hits a high. Says Arvind Rao, certified financial planner, "In order to tackle inflation head on, invest 10%-15% of your portfolio in gold. While gold will not help you rake in 40%-50% returns like equities, you can be sure of 10%-12% in the long run".
  • Real estate : Investment in real estate is lucrative but liquidity is a major issue. If you're an NRI, monitoring your property here in India can get difficult. Yet, around 25% to 30% of your portfolio should constitute real estate as a hedge against inflation. 
  •  Mutual funds: Depending on your risk profile, 50% of your portfolio should constitute equities. "To make the most, invest in banking and infrastructure sectors as also gold mining funds. Note that around 10% of your portfolio should constitute debt in order to cushion the ups and downs of the market and rake in the most out of your money.

Inflation today is caused more by global rather than by domestic factors. Naturally, as the Indian economy undergoes structural changes, the causes of domestic inflation too have undergone tectonic changes. It is time that we think about a revaluation of the Indian Rupee as a policy response to the complex issue of managing inflation, while simultaneously address the constraints on the supply side on food grains through increase in domestic production.


1. The Hindu , Saturday , May 03 -2008



Ms. Navya V
Faculty Member (Finance)

Source: E-mail June 19, 2008


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