Inflationary woes – tackling inflation by prudent investment
“By a continuing process of inflation government can confiscate, secretly and unobserved, an important part of the wealth of their citizens” – J M Keynes
The word inflation is on everyone’s tongue these days, right from the stock market players to the average homemaker. Food inflation has been spiraling out of control and with some sections of the government bluntly accepting that there is little they can do about it, inflation seems to be the biggest worry today. Food prices have steadily risen to their highest prices in a year at rate of 18% per annum. The wholesale price index (WPI) increased to 8.43% in December 2010 from 7.48% in December 2009. The RBI has raised its projection for expected inflation to 9% this fiscal as compared to 3.8% last year. This is a very high increase!
Inflation is no simple thing and it is driven by many factors, one of them being the dependency of our country on the annual monsoons. Any anomaly in the monsoon causes havoc in the prices. But it’s not just the local weather pattern that affects inflation. Global events too are responsible. In today’s time when all the markets are dependent on each other for various resources, a problem in one particular country can cause global commodity prices to go up uncontrollably. Recently when bad weather destroyed the wheat production in Russia, global prices of the commodity went up almost 30%! This shows how different markets are closely linked to each other. The last global food crisis was in 2008, when spiraling food prices caused riots in 25 countries around the world.
There are a number of factors for retail inflation in both consumable and non consumable goods. The ill equipped farming sector in the country is underfunded and unorganized. According to the Asian Development Bank’s report Agriculture sector study: Critical issues and strategic options, “The growth in all segments of Indian agriculture has declined from 1996-97 to 2003-04. Overall, the sector grew 1.8% from 1995-96 to 2004-05. The growth rate from 1984-85 to 1995-96 was 3.6%. The stagnation is most evident in food grains as their per capita availability was 186 kg in 2004-07 as against 207 kg in 1991-95.”
Food inflation is rising not only because of the poor techniques of farming or the unorganized nature of the sector. It also increases due to the poor and faulty distribution networks. Wastages in transportation and storage are a big headache and are a part of a larger systemic problem plaguing the sector. Controlling these losses is essential to control sudden rise in the prices. As the population goes on increasing and so does the standard of living the demand for food articles is growing. Increased disposable income leads to more choices for the people and thus more demand. The era of cheap food in developing countries seems to be coming to a premature end. Rising fuel prices further add to the woes by increasing the distribution cost of food and other goods.
One of the most obvious impacts of inflation is the fall in the standard of living. When people are forced to pay more for the way they are living they either have to cut down or save less. Either way their way of living is impacted considerably.
With rise in prices government has to take tough monetary decisions. Interest rates are hiked. RBI has raised the repo and reverse repo rates by 25 bps to 6% & 5.5% respectively in its quarterly review on 25th Jan. increasing interest rates makes borrowing more expensive for individuals and corporate thus increasing the cost of operations and eating into the bottom line. People who have variable interest rates find that their interest rate has been reset and now they have to shell out more on interest payments leading to further erosion of income.
People at the bottom end of the pyramid are hit the most. Most of their expenses are for basic commodities. As prices of these rise they find themselves paying more just to get the essentials and thus are left with very little or no savings. On the other hand people with more disposable income or people who have the ability to significantly ramp up their income with rise in prices are usually invested in inflation offsetting assets. It is not unusual to find the gap between rich and poor increase during the times of inflation.
With less income that can be classified as disposable people resort to less expenditure on goods and consumer services severely affecting the demand of these goods and services. A fall in the demand may force the manufacturers to reduce their output, thereby leading to idle and redundant workforce. Companies may resort to cutting down manpower to cope with the low demand. Thus inflation may give rise to unemployment. This might be a major cause of concern in countries recovering from economic crisis as growth is needed to maintain a stable level of employment.
Inflation has an adverse impact on trade. Increasing prices of raw material mean increase in operating costs. This leads to higher cost of domestically produced goods. These goods can’t compete with the goods of other countries which have better managed their inflation. Exports take a hit. Further if cheap alternatives are imported from other markets then it further adds to the woes of the local industry. An excessive inflation rate is thus a worrisome prospect for any government.
It is during these harsh economic times that creative solutions need to be applied to have a better grip on ones finances. A good way to start is to save more. A good savings cushion provides a lot of help in inflationary times. But this is easier said than done. It is hard for people to make do with less when they are used to more.
Debt is an additional burden when interest rates start going up, especially if you are on a variable rate loan. Banks and financial institutions are bound to increase their interest rates when RBI tightens its monetary policy. A rise in interest rates means an increase in outflow of money that goes into servicing these debt obligations. Spare cash might help in this situation and it should be used to reduce the monthly outflow of money.
Health related costs go up in inflationary times. A good health cover will reduce the risk of losing your savings to diseases. Life covers are essential for people who have dependants. However before selecting a particular insurance product one must make a thorough examination of what’s on offer.
Investing in inflationary times is a tricky business. One must take care that the investments generate returns that can outpace the inflation. Young investors can put their money in assets that are likely to appreciate in value over time. They can invest in equity, property, precious metals. Depending on the risk profile, one must invest certain amount of funds in equity and property.
Equity has always been used by investors to hedge against inflation. However care must be taken that the capital appreciation and the dividends from the equity can keep pace with the inflation. Thus care must be taken to invest in stocks that are strong bets and are likely to outpace inflation over time. Investments should be made carefully in companies that have a sound performance. Performance alone should be the criteria for investment. One should not invest in penny stocks thinking that they will generate huge returns. Blue chips are preferable than mid caps or small caps.
For middle aged investors protection of their wealth should be top most priority. They can consider investing in bonds. Prices of fixed rate bonds decrease on the presumption that higher yielding bonds are likely to be issued due to increasing interest rates. If inflation rises after the bonds have been acquired by the investor, the returns on the bond will be diminished. The opposite happens when interest rates fall. The longer the investor holds on to a bond the more the exposure to interest rate risk. It is advisable to look at variable rate bonds even though you don’t get tax saving options on them.
Investing in precious metals like gold is also a famous hedging technique used by investors. Although gold and other precious metals have been favoured as safe havens in times of economic crisis, their value also fluctuates like any other asset out there and they are not entirely a safe bet against inflation.
If the investments have not grown in accordance with the prevailing as well as the anticipated inflation then retirement may have to be delayed. While it is difficult to arrive at a figure that might be sufficient for retiring, it is wise to factor in the medical costs and other contingencies. Elderly people may also need assisted living if they are not supported by their family and this will significantly add to the expenses after retirement.
Investing money smartly and making investments that outpace inflation is what creates real wealth. With sound financial management it is possible to stay ahead of inflation. This requires considerable efforts and caution on part of the investor. Although inflation has been studied in great detail, it still remains an enigma for economists because it is not only driven by economic factors but also by psychological ones. As humans are unpredictable so is inflation.
- Swaraj Singh Dhanjal
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