You remember the time when your parents told you how cheap gold was when they got married. Conversations about low salaries and expenses of the past are common in households. Fundamentally, all these discussions are about ‘inflation’. It is the frequent rise in prices of goods and services that you consume every day.
The inflation in the economy is your biggest enemy when it comes to money.
Your money today is not worth so much 10 years from now. This is because inflation pulls down the value of your money. If you are looking to create wealth for yourself in the future or save for retirement or your child’s education, your investment must beat the inflation rate consistently. That is the least it should do.
While your financial advisor will appropriately help you with choosing the right investment avenue, it may be a good idea for you to know more about inflation prospects ahead. If you are aware of this, you may be able to take a better decision along with your financial advisor.
Prices of goods and services are set on the basis of the demand and supply in the market. When the demand soars or supply is low, prices rise. When the demand is low and supply is high, prices fall. However, since we do not have a barter service and use the currency to buy goods and services, it is the supply of money that determines the inflation rate in the economy. This is controlled by central banks in an economy.
The Reserve Bank of India is responsible for managing the inflation and the money supply in the Indian economy. The Monetary Policy Committee of the RBI sets the repo rate that effectively determines interest rates that we pay for our loans. It is the rate at which RBI lends money to banks. Banks use the repo rate as a benchmark and set their lending rates to us accordingly. When the repo rate is set high, banks tend to hike interest rates. When it is cut, banks tend to pass on the benefit to borrowers.
The RBI committee meets every two months to set borrowing rates. The process is called the credit policy. Besides a detailed monetary policy statement that the RBI publishes after every credit policy announcement, it also publishes minutes of the committee meeting. Members of the committee are learned people who assess the prevailing market conditions and make observations. They give their view on the rate of borrowing or the repo rate and the policy stance.
In the recently held meeting in the first week of October 2018, the RBI committee members decided to maintain policy rates at current rates. However, they changed the policy stance from ‘neutral’ to ‘calibrated tightening’. The RBI minutes of the meeting outlined that calibrated tightening of policy rates would mean lowering interest rates is off the table. The committee would look for signals of rising inflation and take a decision accordingly to raise borrowing rates. This is an important clue for you.
The inflation demon hurts you in three ways:
It erodes the value of your wealth: Your savings are worth less every year. The inflation eats into the value of your money. If inflation keeps rising, you will have to work harder to increase your income. At the same time, you will have to invest in a way that your investments generate a higher return than the prevailing inflation. Rising crude oil prices are an important factor as India imports 80 per cent of its annual oil needs.
Your expenses rise: The cost of goods and services rises. Your existing floating rate loans become expensive. That leads to your monthly outgo rising. In many situations, people resort to repayment of loans with cash in hand to reduce the high-interest rate burden.
Your investments slow down: High inflation means interest rates would remain high. This typically results in higher returns offered on bank or company fixed deposits or government schemes. It also leads to a weakness in equity markets too as interest rates and equity markets have a reverse correlation. If guaranteed returns are higher, you do not want to take chances by risking your money in equity markets or any other investment.
What should you ‘not’ do
When inflation is high and interest rates are rising, you need to either increase your income or generate higher returns or both. A promotion with a raise in pay would be timely. If you have to bring down your monthly outgo, do not stop your regular equity-linked investments. You need the higher returns of equity markets to beat the inflation. A rising exposure to equity markets over your working years is your only weapon to crush the inflation demon.
(The writer is editor and publisher at Simplus Information Services)
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