What does inflation mean to anyone? Does it really affect you? If we look a few months back, everybody was talking how America will do. Will it be able to maintain its investment in India and so on! Nobody was talking about domestic issues. Now look today. Every now and then we hear the finance minister talking about current account deficit and fiscal deficit. So if a person like finance minister talks about such issues, it’s a signal that there are problems for our economy in future. Current account deficit which is 3 per cent at this moment is expected to go up to 5 per cent and fiscal deficit is expected to be pushed to 9 per cent from the current 6 per cent.
What is inflation? Inflation refers to the rise in the price of products and subsequent fall in the value of money. Suppose the price of a product today is Rs.100 and the inflation today is around 10 percent then, the price of product next year would be Rs.110. Therefore, the product that you could buy today for Rs.100 will cost you an extra Rs.10 next year. So, in other words the value of your Rs.100 has decreased by Rs.10 or the product has suffered an inflation of 10 per cent. Therefore, whether you are a salaried person or self employed, you cannot escape from the monster inflation. You need to insulate yourself from this. What are the risks?
Every investment must cover the inflation risk. Many people get it wrong. Suppose you invest in a fixed deposit that pays you 8 per cent per annum. If the expected rate of inflation is 5 per cent, the real rate of return is only 3 per cent. This is because while the Rs.100 will grow up to Rs.108, the price of the product will move from Rs.100 to Rs.105. So, a year later there is only Rs.3 addition to your wealth. Now, look at the present scenario. The expected rate of inflation this year is around 11 percent (remember crude oil is expected to record new heights every day). So, in real terms your investment has grown from Rs.100 to Rs.108 but the price of the product has risen to Rs.111. You have lost Rs.3.
Second is the interest rate risk. Interest rates are volatile. They don’t stay static. They move up and down. Interest rate risk refers to the impact that the rising interest rates have on bond values. When interest rates go up, the value of the existing bond prices come down and your yield goes up. Same is true for the reverse. Say, a company issues a bond with a face value of Rs.100 and a coupon rate of 8 per cent. Say, its current market price is Rs.100. Now look at this amongst the rising inflation. Interest rates will be increased by RBI to curb the rising inflation. Suppose, now the company issues a fresh bond with a face value of Rs.100 and a coupon of 11 per cent. Does this mean any thing to you? You will surely sell the earlier bond with a lower coupon and buy this new bond with a higher coupon. But who will buy your bond? The prices will come down to a certain level which would give a return of 11 per cent. Therefore, rising inflation may lead to interest rate hike and fall in the value of existing bond.
Then, there are default risk, liquidity risk and the re-investment risk. Liquidity risk can be when you want to exit from a bond but due to high interest rates, you have to sell at a lower price. Similarly, re-investment risk means when your deposits say in mutual fund or fixed deposits cannot be invested back at the same rate. It is invested at a lower rate.
Thanks for this fabulous post. very informative and interesting. I think these days everyone talks about inflation but no one really explains it well. Your is a blog that has very nicely achieved this. The only other source where I got good information on how inflation affects the common man was UTVi. They had a show where they went to a family and figured out how their expenses had shot up in recent months owing to inflation.
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