Purchasing Power and Inflation

Inflation based on the whole sale price index is at a 13 month high at 6.68%. Inflation refers to a general rise in price levels, and they’re rising at the rate of over 6% a year. In India, whenever elections are around the corner, inflation is a top political issue. In the past, onions shortage and prices have given the government the jitters. Inflation can give he RBI governor sleepless nights, because its effect is powerful. If the inflation rate is 5% a year, it means something that costs Rs 100 a year ago now costs Rs 105. If we go back to, say the 1980s, a movie ticket cost around Rs 10. Today, at the INOX multiplex in Nariman Point (Mumbai), it costs Rs 200 – a 20 fold rise in about 25 years. That’s inflation. If we had futures contracts on movie tickets that we could trade on exchanges then one could have hedged against movie ticket inflation in 1980.

Most of us don’t give much thought to the fact when we hold hard currency like Indian rupees with us, we’re really giving an interests free loan to the government.

Inflation erodes the purchasing power of paper currency like the rupee. So, after a few years, Rs 100 will buy less than they can buy today. So, by hanging on to currency notes, not only are you giving the government a interest-free loan, you’re also losing purchasing power. Not a very good deal.

There’s another way inflation plays an important if somewhat strange role in our lives. Higher inflationary expectations (expected price trends) alter the saving spending and investment patterns of people. If everyone expects higher inflation, people will tend to spend and invest rather than save and vice-versa. If you took a loan you stand to gain vis-à-vis creditor if inflation rises and the interest rate is not high enough to compensate the lender.

Zimbabwe is a classic example of the havoc inflation can wreak. The international Monetary Fund estimates there is 150,000% this year that means a loaf of bread becomes more expensive between the time you leave your house and the time you reach the shop.

Inflation also affects future expectations of returns from assets:

For instance bond or stock process will fall if inflationary expectations are high since investors will expect higher returns to compensate for higher expected inflation. This phenomenon is called the ‘inflation risk premium’. If stocks returned say 10%, and the inflation rate was 5% the real return is only 5%.

Recently the Indian economy has witnessed inflationary pressures due to strong economic growth, demand pressures and inadequate supply response to the same. Prices of food, primary articles, and oil have triggered inflationary pressures. Real inflation is hardly reflected in the data released by the government in form of WPI (wholesale price inflation) or CPI (consumer price inflation). The administered pricing of petrol results in the understating of inflation. In the past, the Reserve Bank of India has consistently maintained that the average citizen has no protection against rising prices that is, no hedge against inflation. In developed markets like the US the Government issued. Treasury inflation protected Securities or TIPS which give investors an opportunity to hedge against inflation. The coupon (interest) are of TIPS is fixed, but the underlying principal moves in tandem with US inflation. At redemption, investors get the value thus arrived at, or the face value – whichever is higher. Banks and financial institutions usually buy wholesale and create a retail market for such securities. A retail investor can buy securities and hedge against inflation. The Indian government and RBI so far have not issued any significant inflation-liked bonds. People have no choice but to rely on traditional methods to manage inflation such as gold. But there are plenty of reasons for our government to issue inflation linked bonds. First, inflation linked bonds would make the government accountable for inflation, since the cost of borrowing will be linked to inflation. Second, offering such bonds at the retail level, where participation is currently minimal, would help the government to broaden the investor base. Third the government could diversify debt service in deflationary (falling prices scenario). Inflation linked bonds would very likely reduce the inflation risk premium embedded in government bonds and FIIs’ access to inflation-linked bonds would allow them to hedge their inflation risks, which are currently expressed in the currency market.