Friday, April 28, 2006

Inflation

“Indians are becoming stronger. Some years two strong men were needed to carry groceries worth Rs.200. But now 5 years old boy can carry the same”

Does this sound as if we are getting stronger as the years progress? Or does this indicate the inevitable scenario of prices of goods rising? Or is it some kind of joke far from reality? We neither are getting strong nor is it a joke. The prices keep increasing every year whether we like it or not. It is technically known as ‘Inflation’ in the financial terms.

Inflation is always measured in %. An inflation of 5% this year means that the price of a good that was available at Rs.100 last year would cost us Rs.105. We (at least I) remember the days when petrol was available at Rs.10 per liter. Inflation does not determine the commodity prices; rather the commodity prices determine inflation

Inflation & Interest rate:
You are planning to buy a TV worth Rs.10,000 now. But a friend of yours is in dire need for the same amount and promises to return it back after one year. As you know that the inflation clocks at 5% an year, you expect the TV to cost Rs. 10,500 next year. So to get the TV at that time you require Rs.500 extra. To be at a no gain/loss state you require your friend to return back with an interest of Rs 500 equaling inflation. Any interest or gain you receive below the inflation rate is not acceptable. As inflation goes up, interest rates also go up. It is essential for one to get a return well in excess of inflation; otherwise he better spends that money right now.

You get a pay raise of 2% in a year when inflation is 6%. During the next year get pay reduction of 2% (-2% raise) when the inflation is 0 %. Which would make you feel good or bad? Naturally and emotionally you feel happy when you got 2% hike and felt bad when it got reduced. However a closer looks suggests that the pay change is negative during the high inflation year and nil during zero inflation year after adjusting for inflation. Experts call this ‘money illusion’. You were delighted to get a 12% interest when inflation was 25%; but feel bad to get 6% during a 6% inflation year. Actually the second is better.
What is more important is

inflation adjusted returns


It is the duty of the government to control inflation by regulating the interest rate. Why does the prices raise? Many people try to chase very few goods. Supply outpaces demand and hence the price increases. However if the government increases the interest rate, people would tend to deposit in bank/bonds instead of buying good. Thus inflation is reduced by indirectly controlling the supply of cash towards fewer goods.

Inflation, Interest rate & stock market:
In the recent past (3-4 years) many people try to venture into stock market. The primary reason has been the reducing interest rates. When the assured interest that could be fetched from bank deposit is no longer worth considering, people look at share market with the intention of getting better returns (even though it is risky). But when the inflation is too high and the interest rate as a result of that is also high, people feel safer to lock their money in fixed income securities as they offer a decent risk free return. This is not only true to individual investor like you and I, but for major mutual fund manager and FIIs as well. Inflow into the share market gets reduced due to high interest rates and hence the market does not move as much as one would love it to. This is just a supply-demand of money part. There is another more important factor. Many companies borrow money to run their business. Revenues after having paid for interest and tax become the profit for the share holders. As the interest rates are high, most of the revenue is eaten up by the interest component and hence very little is left for share holders in the form of profit. Worst hit are the companies that are heavily leveraged with barrowed fund. So.. Watch out for companies with high debt-equity ratio during high interest rates.

Inflation is not the only factor determining the interest rate in a country; it is just one of factors. We would talk various such points later in this group.

Please feel free to pass on you comment/suggestions/feedbacks.

Punch Dialogue:
It does not matter whether you are right or wrong; but how much you gain when you are right and how less you loose when you are wrong.

By: Kuppusamy Chellamuthu

5 comments:

Anonymous said...

I was imagining inflation as something big & not to the knowledge of common man. This is a simple explanation. Keep writing.

- Raghu

Anonymous said...

[Supply outpaces demand and hence the price increases]. Is this a right statement? The reverse statement would be right, i.e, Demand outpaces Supply and hence the price increases!

- ViLakkennai Kannan

Kuppusamy Chellamuthu said...

thanks for notifying the error Mr.Kannan. Point well received.

William Vo said...

Hey, cool blog. You should definitely get it list on Edex blogs

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