How does inflation affect you?!

You might be enjoying your cup of tea at a tea stall or you might be having a sumptuous meal in the afternoon!  Even here or especially here you will feel the pinch of inflation. This article explains inflation in detail. It also helps you with suggestions to get the better of it.

Inflation

According to the rule of economics, inflation is the increase in the average level of prices for goods and services. A sample basket of goods and services is used to get an estimated figure of the change in prices because it is not plausible to calculate change in prices of each and every product and service separately. Inflation is primarily of two types: demand-driven inflation and supply-driven inflation.

• Demand Driven Inflation: Say, one year ago you had Rs. 1000 to buy 100 products available in the market assuming you are the only person to buy these products. One year later you have Rs. 5,000 to buy the same 100 items available in the market. What do you think the price of these items will now be?  The prices of these items will now be 5 times on an average. This phenomenon is termed as demand-driven inflation when too much cash chases too few products. That is to say the demand outstrips the supply.

• Supply driven inflation: It is exactly opposite of demand-driven inflation which occurs due to supply constraints of important goods or services.  This means the price of products will increase because of the lack of availability.

The RBI has been hiking its key policy rates to address inflation concerns and it recently did so for the 11th time since March 2010

How inflation is measured in India

Every week, RBI comes out with an inflation number. This number is measured by using an index called WPI (whole sale price index). WPI is the average price level of goods traded in wholesale market. These are divided into different categories viz. primary articles (Food articles, non food articles and minerals.), Fuel, Power, Light & Lubricants and manufactured goods. The average price level is then measured on a weekly basis with the respective weightage given to the different categories.  The percentage increase with respect to a base year is referred to as the inflation rate.

The government has shifted the base year for the official wholesale price index to 2004-05, from the earlier 1993-94, and added as many as 241 new items to its basket of commodities. Earlier there were 435 commodities. The weightage given has also been changed. This will help in getting a more realistic picture of inflation.

Let’s calculate WPI for a commodity like wheat. Assume that the price of a kilogram of wheat in 2005 was Rs. 20 and in 2011 is Rs. 25

Then WPI of wheat for the year 2011 is,

(Price of Wheat in 2011 – Price of Wheat in 2005)/ Price of Wheat in 2005 x 100 which comes out to be (25-20)/20 x 100 =25
Since WPI for the base year is assumed as 100, WPI for 2010 will become 100 + 25 =125.

As the inflation figure is an average increase in price levels of goods and services, the actual increase in cost of a good cannot be correctly estimated. For example if you want to estimate the increase in housing prices, the inflation figure won’t be the correct measure. The housing prices have increased astronomically over the past few years.  The housing price would primarily depend on the location and the expected development in the region.

Plan to combat inflation

• If you are an investor primarily investing in bonds or fixed deposit, then this is high time you rethink your investment plan.  As inflation erodes the value of money, high inflation would eventually lead to low real returns.  Under high inflationary conditions, the interest rates ate expected to move up which means new investors will get higher returns. Therefore, it is advisable you put your money in short term funds instead of long term deposits or government bonds.

• Going by the same concern, you should also get rid of the long term debt funds. As interest rate increases, the bond prices fall this in turn reduces the NAV (net asset value) of bonds. Hence, you should move to the short term funds which is not very sensitive to interest rate risk

• Reconsider your investment decisions. As inflation increases, it is better to invest in equities which give superior returns in long term. Hence, if you are a long term investor then you are better off investing in mutual funds which are run by adept fund mangers.

• As interest rates move up, it is better to invest in properties. It is expected that during times of high interest rates, the property rates will also move up.

• Also, it is important that you have diversified your risks by investing in different asset classes.