Inflation for dummies

‘Dummies’ is just a famous tagline with the whole line of books but otherwise yes I was looking for an article named the same as above as I closely relate to it. I never found one though so here I am, writing one.

We all know that when inflation happens, general prices increase which basically means that the purchasing power of the money we have has declined. India has managed to keep the rate below 2% for the past decade and we'll see how below.

Measuring inflation is done by checking the cost of a set of products named the Market Basket over time. They are checked on two indices, Consumer Price Index(CPI) and Producer Price Index(PPI). Over the long term, both are the same but for investors, they look into the PPI as it increases before the CPI for obvious reasons.

The Government controls the inflation rate by changing the interest rates. Inflation is the cost of saving money whereas interest rates are the cost of borrowing it. Consider the interest rates dropping, this will increase more cash flow and more spending which in turn increases the price of products leading to inflation. The exact opposite is a deflationary spiral which leads to a huge reduction of prices due to inadequate money flow.

This is precisely why we need to know the difference between nominal interest rate and the real interest rate which is the result of the difference between nominal and inflation. The nominal rate gives you the growth of money but real interest rate gives you the growth of purchasing power.

So how does this affect the investors? In a longer run, company revenue increases at the same pace as inflation benefitting investors as stock prices increase. However, this could also be deceiving as the company is not prospering due to its own efforts but merely due to inflation. Commodities such a gold etc have a good hedge during inflation as the resources are limited and hence price increases but this is in contrary to perishable goods.

Bond investors bare the hardest hit as their money’s purchasing power has been reduced which implies real return is also less than the initial amount given. Inflation benefits borrowers at the expense of lenders. However, there are special securities which are not affected by inflation such as Treasury inflated protected securities (TIPS) but with a low rate of return.