Inflation decrypted

Have you ever wondered about what is inflation? How it affects your investments?I will try to put whatever I have learned and read.

Here is the standard definition: In economics,inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the price level rises, each unit of currency buys fewer goods and services.

Indian inflation rate is based on wholesale price index (WPI) . A set of 435 commodities are used to calculate WPI. WPI is available at the end of every week (generally Saturday), for a period of 1 year ended that day.

In my words, Inflation is some number which increases when price of certain commodities is increased compared to it’s prices in last year. Whenever inflation increases buying power of rupee decreases. Here is a simple hypothetical example, suppose you’re an employee in some firm. You get X amount as a salary for a particular month, inflation rate was 3% in that month. Next month you get the same amount as a salary but inflation rate rose to 5%, you’ll be little bit short in your monthly budget. Don’t blame your wife, it’s inflation. You may wonder that your requirements didn’t change over a month but still you didn’t fall within your budget. It’s because inflation rose which reduced your buying power with same amount of salary you got. In real world you cannot find this difference within a month, yearly comparison will give you a better idea.

How it affects your investments:

Many of us never thought of this hidden figure when we get return on our fixed income investments. I know many people who considers themselves as safe investors by investing their money in fixed deposits, I am agreeing with them on “safe” part but not with “investor” part if they haven’t predicted or considered inflation rate. If a person is buying a fixed deposit today at 8%. Is he really getting 8% return on maturity? No!!, Assuming inflation was positive for the year, purchasing power has fallen and, therefore, so has real return. One has to take into account the chunk inflation has taken out of return. If inflation was 4%, then his return is really 4%.

Right now rate of inflation in India is -0.21% (22nd August’09).

Currently fixed deposit rates in India are 6.75%-7%, I would not recommend to invest in FDs at this point of time because inflation is negative right now, eventually it’ll go up by next year so effective rate of return will be 3.5-4% depending on the inflation rate at that time. Instead of investing in FD, i would recommend to invest in gold or silver if you want to play safe. Gold is almost 16000 when inflation is negative. I see lot of upside in these commodities when inflation will start rising.

I don’t think Indian markets will come down today but there will be some profit booking.

Happy Investing !! Off to make a delicious pav bhaji today )