Inflation and Its Impact

Mintd Team
June 25, 2022

Wondering what’s the buzz around rising inflation in India and across the world? Well, all the buzz is because the world is witnessing a high inflation economy. But what exactly is inflation, and how does it impact me? Inflation is the rise in prices of goods and services or a decline in money's worth. Too much demand for too few goods or services raises prices. Higher prices in one sector don't lead to economic inflation. Price hikes across categories will lead to inflation and reduce consumer buying power.

Before we move ahead to know the impact of inflation, let's understand what is causing a rise in inflation?

The current inflation is an after effect of the COVID-19 pandemic, strong consumer demand fuelled by historically robust job and pay growth along with unprecedented fiscal stimulus, and the Russian invasion of Ukraine. Pandemic and war-related supply chain disruptions are just adding to the pressure. High global energy and raw material prices and a weak currency drove India's largest annual wholesale price rise in 30 years. As a result of high commodity prices, India is witnessing a high inflationary economy.

Impact of Inflation

 In addition to a consumer's purchasing power, inflation also impacts interest rates, investments, and companies. Let’s understand the impact of inflation on:

  1. Interest Rates:
    To curb the rising inflation, the country’s central bank will increase the interest rates to minimize the impact of inflation. High-interest rates will suck the liquidity out of the system. A decline in money supply will reduce consumer expenditure. As a result, consumer demand falls. With stable supply and diminishing demand, prices will decline.
  1. Investments:
    The impact of inflation on investment is different across asset classes:

    i. Equity
    Inflation causes market volatility. Stock market returns and pricing depend on future profit expectations. Inflation can decrease a company's rupee earnings, making it difficult to evaluate. Higher wages, inventory, and supplies might affect company earnings. Consequently, stock values fluctuate. However, investing in the market is a long-term business. Thus, you don’t have to worry about the impact of the short-term volatility. Stay put with your investments and let the dust settle. Long-term passive investing offers market and inflation-beating returns.

    ii. Bonds
    Bond yields, inflation and interest rates move in tandem. However, the bond prices have an inverse relationship with interest and inflation. When the interest rates increase, the bond prices fall. Thus, all the long-term bonds become un-attractive. On the other hand, higher interest rates work well with short-term bonds. Since the bond prices and inflation move in opposite directions, it is wise to keep away from long term bonds during inflationary periods.  

    iii. Gold
    Inflation makes consumer items more expensive, which devalues the rupee. Since gold is rupee-denominated, its prices rise with inflation. Thus, investors would change their cash holdings to gold to protect their assets' value. Hence, gold works well as a hedge against inflation. The increased demand for gold continues till inflation is under control.

    iv. Real Estate
    Real estate has a complex relationship with inflation. On one hand, inflation makes all goods and service more expensive, including the inputs that go into construction, thereby increasing real estate prices. On the other hand, an increase in interest rates causes an increase in mortgage rates, which reduce consumer demand for new homes. We also often see an increase in rental prices during inflationary periods. These competing forces play out in unpredictable ways in the real economy.

    v. Fixed Deposit
    Fixed deposit returns barely beat inflation. An FD's real return may be negative with high inflation. Let’s say if an FD scheme offers 4.5% interest and inflation is 6.5%, then the real return is negative 2%(interest – inflation). To top this, the interest from FD is taxable. Now, the actual return is even lower. Thus the money loses purchasing power or devaluation of the capital on maturity.

    vi. Cash
    Holding cash will not generate money. Only when you invest, money generates more money. Each rupee will buy a lower quantity of goods over time. Say you are purchasing 1 kg of rice for Rs 100, and in an inflationary economy, you may not be able to buy the same quantity for 100 one year later. Thus, holding cash will only lose its value. Therefore, always invest in assets that will help you generate inflation-beating returns.
  1. Companies:
    Shortage of service or product and higher costs across the board (raw material, labour, rent, utilities, and gas) force businesses to raise prices. Furthermore, higher interest rates increase a company's capital costs. Thus, the growing costs make it harder for companies to reach good margins and profitability.
  1. Consumers:
    Inflation isn't just an increase in the price of one single good or service; it is the increase in the price of a basket of goods and services. Thus, everything is more expensive than a couple of years ago. The spending power of the consumers reduces, thus lowering the demand for goods and services. Higher interest rates will lower consumer borrowing. Therefore, everyone tends to pullback on discretionary spending.

How to manage inflation risk?

Diversification reduces inflation risk. Aim for an inflation-resistant portfolio. Investing in passive schemes like index mutual funds and ETFs will expose you to the industry’s best stocks. As they are the best players in their segments, the impact of market volatility will often be lower. Never panic looking at the short-term volatility. Always invest with a long-term horizon. During strong inflation, avoid holding cash and investing across long-term debt schemes. Thus, strategically allocate your funds to schemes that will help you generate inflation-beating returns over time.

Furthermore, you need to adopt watchful spending habits. Spending must be monitored, and avoid unnecessary purchases. Over time, spending changes will become more impactful.

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