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Does Inflation Matter?

Updated: Jun 16, 2022

Did your parents ever say you are spending more than what they did at your age? This is quite common and understanding inflation helps you counter their statement. (Thank me later)


Do you remember buying something for less price in the past which is costing more in the present? This is what inflation means, the rise in the price of goods and services with time and thereby reducing the power of money. This is represented in percentage and the present inflation is 7% June (YoY- year on year) which means the same goods which cost you Rs.100 back in June 2021 are costing you Rs 107 currently. Negative inflation is called deflation. To calculate this data, they consider a set of goods and services and see the change of price at a consumer level and thereby called the Consumer Price Index (CPI) alias Inflation figure.

Lets now see why this figure varies at all. Assume that the supply of goods is constant whereas people are earning more or getting money at a cheaper interest rate from local banks. So, all one does is borrow money, buy and keep spending on goods and services. Supply being constant, this surge in demand leads to an increase in the price of products which is how inflation rises. But how far can this figure go? 10%? 20%? 100%?. Nooooo way.

The Reserve bank of India (Bank of banks) wants this number to be at 4 or in the range of 2 to 6 and they control it by various methods. One way is to increase/decrease the supply of money in the economy. Let's assume that the inflation is at 10% and the RBI wants it to bring back to 5%, so they either try to pull the money from the economy (people) or reduce the supply of money into the economy by increasing the repo rate (the rate at which banks borrow money from the RBI). So increasing this rate will discourage local banks to borrow money from RBI and thereby these local banks like SBI, HDFC, ICICI, and others increase the rate at which we borrow money from them. So the money circulation in the economy decreases and the cash in the hands of people decreases leading to a decrease in the demand for goods and services. This ultimately brings down the prices and inflation gets controlled.

The reverse happens when inflation decreases. This historical CPI (Consumer Price Index- Inflation) data can be found here.



(Image Source: shorturl.at/fkGX8)

Due to COVID 19, many companies got shut, people stayed at home and there was no spending which lead to a decrease in inflation (Deflation). To bring it back, there have been multiple cuts in the interest rates and the current repo rate is at 4%. So, next time when the RBI cuts or hikes interest rates, I hope it makes a lot more sense. Here is the Repo rate data from the year 2001.


Knowing all this, how can one beat inflation?. It's possible only If one can increase the money at a rate more than inflation. For those who are not aware, the so-called safest bank (SBI) has a rate of return of around 3% in a savings bank account, and inflation being at 7%, one is actually losing the value of money by 4% being deposited in the banks. So, the only solution is to look for investment opportunities where the rate of return is at least 7%. Fixed Deposits have a return of around 7% and there is a lockin period of 1 year. So, one can invest in fixed deposits just not to lose the value of money.

If you know any source which could give a return of more than 7%, please share it in the comments.

(Fun fact: Inflation is why most of the companies hike salaries by 10% at the end of each year.)


Knowing all this, let's try to relate how the markets react factoring in these figures. Let's say your friend lives in the United States where the interest rates are close to 0 whereas the interest rates here in India are around 4% at the same time. So it makes sense to borrow in America and invest in India (Ignoring the complications). During covid when the Central Banks reduced the interest rates, the FIIs (Foreign Institutional Investors) Started investing in India with the hope that they can get a decent return. Once the situation started to normalize and the Inflation started to rise due to monetary stimulus by the governments, the central banks started Increasing the rates to control inflation as discussed above. So it's again a normal tendency for the FIIs to pull the money from Indian markets and invest back in the so-called safest heavens- Banks. So for the past few months, this has been the major reason for the fall of Indian Equity. So in a Nutshell, Inflation does matter to everyone directly or indirectly.


For those who want to try their hands on investing, trading or finance here are a few resources one can start looking at.


- with love


 
 
 

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