Inflation & investments

INFLATION

Inflation is?the rate of price increase over a given period. Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country. Inflation is a rise in prices, which can be translated as the decline of purchasing power?over time. The rate at which purchasing power drops can be reflected in the average price increase of a basket of selected goods?and services over some time. The rise in prices, which is often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods. As inflation occurs, purchasing power decreases, meaning that it costs more to buy the same good or service, or that the same amount of money buys fewer goods and services.

There are three primary types of inflation:

• Demand-pull inflation
• Cost-push inflation
• Built-in inflation

Demand-Pull Inflation

Demand-pull inflation describes how demand for goods and services can drive up prices. If something is in short supply, you can generally get people to pay more for it

Cost-Push Inflation

Cost-push inflation often kicks in when demand-pull inflation is going strong. When raw materials costs increase for businesses, the businesses in turn must raise their prices, regardless of demand.

?Built-in Inflation

As demand-pull inflation and cost-push inflation occur, employees may start asking employers for a raise. If employers don’t keep their wages competitive, they could end up with a labor shortage.

If a business raises workers’ wages or salaries and tries to maintain profit margins by raising prices, that’s built-in inflation.

Consumers’ cost of living depends on the prices of many goods and services and the share of each in the household budget. To measure the average consumer’s cost of living, government agencies conduct household surveys to identify a basket of commonly purchased items and track the cost of purchasing this basket over time. (Housing expenses, including?food & beverage, rent, etc .) The cost of this basket at a given time expressed relative to a base year is the?consumer price index?(CPI), and the percentage change in the CPI over a certain period is?consumer price inflation, the most widely used measure of inflation. (For example, if the base year CPI is 100 and the current CPI is 110, inflation is 10 percent over the period.)

Some facts about Consumer Price Index

• The Consumer Price Index (CPI) is a measure of price changes in a basket of consumer goods and services purchased by households.
• CPI is a numerical estimate based on the rates of a selection of typical objects whose prices are collected regularly.
• The Consumer Price Index (CPI) measures price fluctuations at the consumer level.
• The CPI is divided into eight categories: education, communication, transportation, recreation, clothes, foods and beverages, housing, and medical care.
• The CPI is published by the?National Statistical Office (NSO)?under the Ministry of Statistics and Program Implementation.
• The CPI uses a?base year?set at 2011-2012.
• The CPI is?published every month.
• The Wholesale Price Index tracks price changes at the producer level (WPI).

The various components of CPI ??and their weights are (Housing inflation is not considered in this)

• Food and Beverage – 45.86%
• Housing – 10.07%
• Fuel and Light – 6.84%
• Clothing and Footwear – 6.53%
• Pan, tobacco, and intoxicants – 2.38%
• Miscellaneous – 28.32%

Now the moot point would be how is CPI calculated

• The Consumer Price Index, or CPI, measures changes in the price of a common basket of goods and services by comparing current prices to prices from the previous year's similar time.
• CPI is calculated using the following formula:

To better understand how inflation is calculated we can use an example. In this example, we calculate inflation for a basket with two items: Food & beverages and housing. The formula for calculating inflation for a single item is below.

The price of F&B was 1000 in 2021 (year 1) and the price increased to 1050 in 2012 (year?2). The price of monthly house rent was 500 in 2021, and this increased to 600 in 2022.

INR)

      Items	                 2021(INR)	2022(INR)	Inflation
      Food and Beverage (F&B)	1000	1050	     5%
       Housing	                 500	550	        10%
        
      
                

Using the formula, inflation for each of the individual items can be calculated.

• For F&B, annual inflation was 5 percent
• For housing, annual inflation was 10% percent

To calculate inflation for a basket that includes F&B and housing, we need to use the CPI weights that are based on how much households spend on these items. Because households spend more on F&B than housing, F&B has a greater weight in the basket. In this example, F&B accounts for 67 percent of the basket, and housing accounts for the remaining 33 percent. Using these weights, and the change in prices of the items, annual inflation for this basket was 6.65 percent – calculated as (0.67 x 5) + (0.33 x 10).

Please remember that CPI is not an indicator of price level

The CPI measures the rate of price changes in the economy, but not the price level. If the price index of bread is 140 and the price index of eggs is 180, it does not mean that eggs are more expensive than bread. It only means that the price of eggs has increased by more than the price of bread from a particular point in time.

So, then what does it mean for our savings and investments?

For investors, the?returns on their investments must be at least the same rate as inflation; if they are less, then their investments are losing money even if it shows gains. Similarly, individuals should ensure that their salaries increase every year by at least as much as the rate of inflation, otherwise, they are technically making less money.

The concept of inflation-adjusted or real returns is important for all investors to comprehend. Put simply, real return = nominal return less inflation.

For example, when a bank savings account gives a nominal return of 4 percent per annum, the real return is negative because the last year’s average inflation has been at ~6 percent -- much higher than the 4 percent bank yield.

There are various investment products which one should examine to construct a diversified portfolio. Some very broad explanations are provided hereunder, however, they are neither complete nor comprehensive.

Inflation impacts fixed-income investments the most due to its inverse relationship with interest rates. As inflation inches higher, investors expected returns to also move higher to beat inflation. But as interest rates on debt instruments are fixed over their term, the prices of these instruments fall as investors sell the existing lower-yielding products and move into higher-yielding ones. So, in a rising inflation environment, fixed-rate debt investments stand to lose the most

Gold is the best inflation hedge as it tends to protect the value of your portfolio in times of rising inflation hence it is also called a ‘premium store of value.

Returns on stock investments generally tend to beat inflation. Investors who want to avoid the volatility?associated with individual stocks might opt for mutual funds. A passive indexing approach is often best since it does not depend on the stock-picking abilities of any fund manager. Exchange-traded funds (ETFs) usually have lower fees than other index funds.

Real estate is another tried-and-true inflationary hedge. Residential real estate and REITs are also good options. Property prices and rental income tend to rise when inflation rises. A REIT consists of a pool of real estate that pays out dividends to its investors.

Inflation tends to cut into a consumer’s purchasing power over time. Fortunately, there are ways of preserving the purchasing power of your savings. That means investing but keeping your level of risk moderate.

So, in summation

• Inflation is the rate at which prices for goods and services rise.
• Inflation is sometimes classified into three types: demand-pull inflation, cost-push inflation, and built-in inflation.
• The most commonly used inflation indexes are the Consumer Price Index and the Wholesale Price Index.
• Inflation can be viewed positively or negatively depending on the individual viewpoint and rate of change.
• Those with tangible assets, like property or stocked commodities, may like to see some inflation as that raises the value of their assets.
• One of the primary motives for the financialization of assets is to protect the purchasing power of money.