Effect of Inflation on Investment

What Is Impact of Inflation?

Introduction

Understanding Inflation is very crucial to investing because inflation can reduce the value of investment returns. Inflation affects all aspects of the economy, from consumer spending, business investment and employment rates to government programs, tax policies, and interest rates. What Compound Interest gives, inflation takes away. Lets see the Effect of Inflation on Investment in this article.

What Is Inflation?

• Inflation is a sustained rise in overall price levels. Moderate inflation is associated with economic growth, while high inflation can signal an overheated economy.

1. Rice: 9 years before it was for Rs. 30/kg and today it is for more than Rs. 55/kg.
2. School Education Cost: From Rs. 15,000/year to Rs. 60,000/year, in last 10 years. Now here, tremendous explosion of options had happened. With increase in school fees, it is attributed to ‘N’ number of facilities schools are providing these days….from snacks to sport facilities to wi-fi, etc. There are schools in Mumbai (most aspired ones) which charge Rs. 5-8 Lakhs/ year.
3. Medical Inflation: It is at 12-15% currently.

• As shown in the above examples, inflation is the steady increase in the price of goods and services. It is measured as a percentage each year. You would need more money to buy the same commodity the next year. Inflation is compounding.
• As an economy grows, businesses and consumers spend more money on goods and services. In the growth stage of an economic cycle, demand typically outstrips the supply of goods, and producers can raise their prices. As a result, the rate of inflation increases.
• If economic growth accelerates very rapidly, demand grows even faster and producers raise prices continually. An upward price spiral, sometimes called “runaway inflation” or “hyperinflation,” can result.

Example

• If a commodity costed you Rs. 1,000 last year and the inflation was 7%, this year the same commodity would cost you Rs. 1,070. And again if in this year the inflation turns out to be 7%, increase would be on Rs. 1,070 i.e. it would be Rs.1,144.9 and not Rs. 1,140. So inflation is also compounding. And here the marginal compounding effect grows dramatically huge over years. The same commodity if inflation is assumed at 7% would cost Rs. 3,869.6 after 20 years. Or you can say that the value of Rs. 1,000 would become Rs. 270.8 after 20 years…!!!
• Now the intention here is not to scare you. A rising inflation is sign of a growing economy. Salaries go up in a rising economy and thus does the disposable income and the expenditure too. So, the need here is to manage inflation and not being scared of it.
• You earn, today your salary, let’s say rises in line with inflation or more than that. Your income can take care of your day to day spending, but for your goals like child’s higher education, marriage, retirement, etc. you need to plan, save and invest today to have a tension free future. In our article ‘Saving vs Investing’,we have stressed on the need to invest and not just to save. 
• Putting your money in avenues, which give you post-tax returns matching inflation, is actually saving and where post-tax returns are more than inflation is Investing. Putting your money into instruments like FD’s, NSC (National Saving Certificate), Post Office Schemes, RD’s, etc. is savings. Investing is putting your money into Mutual Funds, Direct Equity, Real Estate, etc.

Why Does Inflation Occur?

1. Cost-Push Inflation

• Rising commodity prices are an example of cost-push inflation. They are perhaps the most visible inflationary force because when commodities rise in price, the costs of basic goods and services generally increase.
• Higher oil prices, in particular, can have the most pervasive impact on an economy.
• Because inflation erodes the value of investment returns over time, investors may shift their money to markets with lower inflation rates.

2. Demand-Pull Inflation

• Demand-pull inflation occurs when aggregate demand in an economy rises too quickly.
• When there is more disposable income with people i.e. when there is more money in the system than the goods that money can buy, inflation occurs. This can occur if a central bank rapidly increases the money supply without a corresponding increase in the production of goods and service.
• More money chasing fewer commodities ie. More demand. Here, Demand outstrips supply, leading to an increase in prices.

How Is Inflation Measured?

• Since April 2014, CPI, i.e. Consumer Price Index is used to measure inflation. CPI reflects retail prices of goods and services, including housing costs, transportation, and healthcare, is the most widely followed indicator. There is weighted average assigned to items in the index. CPI of housing is 10.07%, fuel and light is 6.84%, clothing and footwear is 6.53%; paan, tobacco and intoxicants is 2.38%, miscellaneous is 28.32% and food and beverages is 45.86%.
• There is another index which was in use even before CPI. WPI (Wholesale Price Index) which of fuel and power is 14.9%, manufactured products is 64.97% and primary articles is 20.12%.

Effect of Inflation on Investment

Inflation : Decompound Interest

While many people may understand compound interest, very few appreciate the decompounding effect of inflation on their money. What compound interest gives, inflation takes away. To put it another way, inflation is effectively the reverse – it’s like decompound interest. Since each year’s inflation occurs on top of the previous year’s inflation, it means that the effect of inflation on investment is just like that of compound interest.

For Example : Effect of Inflation on Investment

• Consider a situation where you invest Rs. 1,00,000 of your money in a deposit which earns you perhaps 8% a year. At the same time, prices are also generally rising at the rate of 8% a year. In such a situation, your compounding returns will just about keep pace with inflation. The actual amount will increase, but what you can do with it, won’t.
• Meaning,if you deposit your Rs. 1,00,000 for 10 years, at the rate of return of 8%, it will become Rs. 2,15,892.5. However, if at the same time on an average the inflation rate is 8%. The effect of return on deposit of Rs. 1,00,000 will nullify.
• Because the things you could buy for Rs. 1,00,000 before 10 years, will cost you Rs. 2,15,892.5 today after 10 years. Therefore, effectively, you have not become any richer. The purchasing power of your Rs. 1,00,000 before 10 years is still Rs. 1,00,000 i.e. Rs. 2,15,892.5 today, after 10 years.
• We all remember what things used to cost in the past – how someone earning Rs. 20,000 a month was comfortably a middle class, 30 years ago. Let’s see, from the point of view of decompounding, the value of Rs. 1,00,000, deminishing at the rate of 8% inflation, in next 35 years.

• That means, your Rs. 1,00,000 today will be of worth Rs. 18,869 only after 20 years, if inflation is considered to be 8%. Since, inflation eats your amount in parts, every year. Therefore, what you can buy today for Rs. 18,869 approx., you will be paying Rs. 1,00,000 after 20 years (because its worth will reduce and will be left Rs. 18,869 only).
• Thus, if you want to understand from the perspective of retirement and your goal is to have worth of Rs. 2 crore as the end of 20 years, you will have to start saving for Rs. 10 crore, then the worth Rs. 10 crore at the end of 20 years will be of Rs. 2 crore.
• Thus, one must plan accordingly, looking at all factors such as inflation, which eats your money and thereby deminishes its value/ worth.

How Can I Protect My Fixed Income Portfolio from Inflation?

To combat the neagative effect of Inflation on Investment, returns on some types of fixed income securities are linked to changes in inflation:

1. Inflation-linked bonds issued by many governments are explicitly tied to changes in inflation.
2. Floating-rate notes offer coupons that rise and fall with key interest rates. The interest rate on a floating-rate security is reset periodically to reflect changes in a base interest rate index, such as the London Interbank Offered Rate (LIBOR). Floating-rate notes have therefore been positively, though imperfectly, correlated with inflation. Many commodity-related assets can also help cushion a portfolio against the impact of inflation because their total returns usually rise in an inflationary environment.