Inflation is regarded as an essential economic aspect which reflects the nature of the economy. It represents the rate at which the prices of goods and services increase for a period. To give a holistic definition we can define inflation as a sustained increase in the general level of prices for all the goods and services that we avail of.
We can take the following example in order to illustrate the concept of inflation:
About three decades ago a movie ticket would have cost a few paise to our pockets. However, over the years it has increased and reached about Rs.100 on an average for a movie ticket. Similarly the income levels have grown whereby a salary of an individual was about Rs.400 which was considered to be decent enough. But today a decent salary for a well qualified individual starts at Rs.20,000. So we observe that in the manner the expenses have gone up, the income levels have also increased. But the role of inflation here lets us feel that the worth of money has reduced with the passing time. Like what people would have done with three generations ago would be much costlier in today’s era.
What are the causes of Inflation?
Throughout the world the economists have framed and concluded that there are several factors which contribute to inflation. It may also be said that not a single factor impacts inflation as it results out of various economic outputs and activities. Some of the accepted theories for the term inflation to exist and impact our lives are:
Demand-Pull Inflation – This is theory is summarized as “too much money chasing too few goods.” Economically the phrase can be defined as the prices are set to increase if the demand is much faster than the supply rate. In other words, if demand is growing faster than supply, prices will increase. This concept usually prevailing in the growing economies is what really has affected countries like India, Brazil, etc.
Cost-Push Inflation- With the cost of raw materials and other necessities increasing the manufacturing companies are bound to increase the prices of the end products. Increased costs include taxes, wages, or costs like fares, etc.
So how inflation could impact your investment?
Learning what inflation really stands for is important as it plays an important role in every aspect of our spending. However more than that we need to understand how it impacts our investment plans. It largely plays an important role to affect our spending habits and further our investments.
Usually the impact of inflation on a portfolio depends largely on the type of security one holds. In case the investor is worried about the impact of inflation while just investing in stocks the worry of inflation might not keep you awake at night. The primary reason for this is that over the long run the company’s revenue or earnings would also increase at the same pace as the inflation would. However one exception to this is stagflation. It means that the economy is running through a bad phase along with the increasing cost could be painful for the stocks too. The main problem with inflation is that the company’s return is generally overstated. At the times of high inflation one company might seem to be performing quite well whereas the fact of inflation is behind the growth.
On the other hand inflation impacts in a huge manner to the fixed income investors. In case the inflation was positive for a period the fixed investment was done and the purchasing power of the investor had fallen the real return would be affected with inflation taking out its chunk from the actual returns. The change highlights the difference between the nominal interest rates and the real interest rates. Therefore as a investor one needs to take a look at their real rate of return whereas they usually refer to the nominal rate of return and forget about their reduced purchasing power altogether.
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Mohan Bhupathiraju
Mohan Bhupathiraju is a co-founder & editor at LastBull.com. Handled multiple projects in BFSI for few of the Forbes top 100 companies. He works in IT industry in the US. Presently working on start up Ideas in Finance & Technology niches.
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Do you see the RBI cutting its inflation forecast to below 7% tomorrow?