What is inflation and how to beat it?

What is inflation?

You might have heard the word 'inflation' many times in the news or in social media. Have you ever wondered what exactly is inflation? In this article, we will understand what is inflation in simple terms.

Consider the following picture

As you can see, 4 apples were costing ₹100 in 2012 and it costs ₹200 in 2022 (assuming the same size and variety). The price of apples has doubled in 10 years!

Why does it really happen? Do the apples really get expensive? Now consider the below picture:

The above picture gives a new perspective. The number of apples you could buy for the same price in 2012 has halved in 10 years. That means the purchasing power of the currency (INR in this case) has reduced over time. This phenomenon is called inflation.

How does inflation occur?

Inflation can occur due to the following 3 reasons:

1. Cost-push: When the production costs increase due to reasons like an increase in the cost of raw materials, increase in employee wages, increase in oil prices, supply chain issues, etc. An increase in raw material or oil price can occur for reasons like a natural disaster, pandemic, war, etc. Any increase in the production cost will mostly reflect in the price of the final product.
2. Demand-pull: When there is a sustained increase in demand for goods or services, it results in a raise in cost due to the imbalance in supply and demand. Demand can increase due to the availability of more money with consumers, resulting in more spending, which results in higher prices.
3. Fiscal policy: The liquidity in the system can be increased by the government through different policies like reducing the tax, production-linked incentives (PLI schemes), and an increase in spending on infrastructure projects. The reduction in tax or PLI schemes results in more money for businesses to spend on capital investments, employee incentives, etc. This puts more money in the hands of the public, thus raising demand. Governments bring such policies to revive the economy, which would have been hit by disasters like a pandemic, natural calamities, war, etc.

Bad effects of inflation

Decreases purchasing power

The obvious disadvantage of inflation is that we will be able to buy less for the same amount of money. So for fixed salaried professionals inflation reduces their actual income, if the wages are not hiked to meet inflation.

Inequality

Consider 2 families: one with a monthly income of ₹10,000 and another with a monthly income of ₹1,00,000. Let's say the price of rice increases from ₹50 to ₹55. Let's assume both the families consume 20kgs of rice per month. So the spending on rice which used to cost ₹1000 will cost ₹1100 now. If we consider their incomes, it is an impact of 0.1% (100/1,00,000) on the family earning ₹1,00,000 and an impact of 1% (100/10,000) on the family earning ₹10,000 per month. So inflation created inequality and hurts the poor most.

Lenders face losses

When a lender (eg: bank) gives a loan to a customer at a fixed interest rate, they will be receiving the repayment on the devalued currency. As interest rates increase during inflation, lenders will have to give more interest to new deposits whereas they will be getting lower interest on old loans.

Hurts bonds and stocks

When inflation occurs, newly issued bonds will have a higher yield than previously issued bonds. This makes the existing bonds less attractive and bond prices fall, as the money shifts from existing bonds to new bonds.

As inflation results in higher interest rates for less risker investment options like bonds, fixed deposits, etc. People tend to shift money from stocks to these safer options (bonds, FD, etc.). This creates a correction (or even a bear market) in the stocks (especially growth stocks).

Can lead to recession

When elevated inflation stays for a longer duration, salaries usually do not keep up with it. Hence people receive a less real salary. This leads to low consumption, causing an economic slowdown and eventually leading to recession (a fall in GDP in two successive quarters).

Benefits of inflation

Most of the time inflation is spoken in a negative tone. However, there are advantages of inflation as well.

Economic growth

Stable and mild inflation is required to keep the economic growth. When there is stable inflation, it makes people buy things in anticipation of an increase in the price in the future, which leads to more demand, resulting in more production. When there is more production, there will be more employment opportunities, putting more money in the hand of the public. This causes a vicious cycle, resulting in economic growth.

Borrowers pay less

If you have borrowed money from a lender with a fixed interest rate, then you will get benefited from inflation. Since the interest rates increase during inflation, you end up paying back the loan in a deflated currency, thus returning less real money.

Boosts real estate

One of the sectors which are benefited from inflation is real estate. If you own a rental house/property which is on a mortgage (with a fixed interest rate), then you can increase the rent to factor in inflation and yet, you will be paying the same amount as EMI as you used to earlier.

How do central banks control inflation?

Since inflation needs to be kept mild, the central banks play a vital role in controlling inflation. In India, RBI has a target to keep inflation between 2-6%. One of the most popular methods of controlling inflation is through monetary policy. RBI has a monetary policy committee (MPC) for this. It is called FOMC (Federal Open Market Committee) in the US.

Inflation can be controlled by an increase or decrease in interest rates. When inflation is high and needs to be brought down, interest rates are hiked. When interest rates are hiked, people tend to save more and spend less since they get more returns. Hence the money spent by the people is reduced and thus lowering the demand and bringing down prices.

A higher interest rate also means that borrowing is expensive and it reduces business expenditure. When interest rates of safer investment options like treasury bonds, and fixed deposits increase, money tends to move from risky assets like stocks to bonds/FDs, thus making raising funds difficult and reducing business spending.

When inflation is very low and the economy is not growing, central banks start reducing the interest rates and encourage spending. When people spend more, it boosts the economy.

When the economy is slowed down due to some disasters like a war or a pandemic, central banks start buying bonds from the government to provide more liquidity in the system. When the economy survives the disaster and starts growing, central banks decide to stop the bond purchase program and reduce the liquidity to contain inflation.

India: Inflation and Repo rate comparison

Here is the comparison between the repo rate (the rate at which RBI lends to banks) and inflation for the 10 years from 2011 to 2020.

As you can see, the average of both the inflation and repo rate is more or less the same. The banks will be giving interest to your deposits based on the repo rate.

If you are smart enough, by now you would have realized that if you keep your money in savings accounts or FDs, your money doesn't really grow. The banks just return you the inflation-adjusted amount (or even less in the case of a savings account, which typically has an interest rate of around 3% in India).

How to beat inflation?

The next question when you have realized that the money you hold is devaluing over the years is, how do I grow my money at a rate higher than the inflation rate so that the money actually grows in real value, not just face value.

This is where investing in the stock market comes into the picture. The following chart shows the performance of NIFTY 50 (index comprising of top 50 listed companies in India) has performed since its inception.

The average annual returns since inception (22 Apr 1996 to 30 June 2022) is 10.46% and the annualized SIP returns are 11.42%. These returns do not include dividends. If you factor in dividends, NIFTY 50 would have returned around 12-13% returns.

Now consider the NIFTY Next 50 index. NIFTY Next 50 has returned 12.76% on monthly SIPs. If you add a dividend to it, it would come to about 13-14%. Clearly, you can see that NIFTY Next 50 has outperformed NIFTY 50.

If you do not know how to pick individual stocks, you can invest in index funds (say, a combination of Nifty 50 and Nifty Next 50) and expect annualized returns of 12-14% in the long term (minimum 7-10 years).

If you want slightly higher returns, you can think of investing in a portfolio of actively managed mutual funds as well.