#006: On inflation

Apr 19, 2021

Before we begin, here is a problem for you to think about:

Case 1:
Inflation Rate 6%, Salary Hike by 2%
Case 2:
Inflation Rate 2% Salary Deduction by 2 %
Case 3:
Inflation Rate 4% , No change in Salary.

As a worker, which case is the most ideal for you?

In all the cases above, buying power falls by 4% but the workers are psychologically better off while accepting offer 1 and worse off by accepting offer 3. Isn’t this uncanny?

Inflation is the decline in purchasing power of a given currency over a period of time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time.

This factor is no way in our control, but a brief idea about it is necessary for everyone of us to know what is happening to our savings and investments. Cognizance of inflation is important to factor this aspect in our investment, financial and retirement planning. In simplest terms…

• Inflation is the general increase in the price of goods and services over a period of time
• Over a period of time the value of money will go down.
• Same amount of money will not be able to purchase as much as it would have earlier i.e. a month or year before.
• Inflation is invisible and eats up our savings and investment.

What Causes Inflation?

Demand-Pull Effect

Demand-pull inflation occurs when an increase in the supply of money and credit stimulates overall demand for goods and services in an economy to increase more rapidly than the economy's production capacity. This increases demand and leads to price rises.

Cost-Push Effect

Cost-push inflation is an outcome of the increase in prices working through the production process inputs. When additions to the supply of money and credit are channelled into commodity or other asset markets and especially when this is accompanied by a negative economic shock to the supply of key commodity, costs for all kind of intermediate goods rise. These developments lead to higher cost for the finished product or service and work their way into rising consumer prices.

Built-In Inflation

Built-in inflation is related to adaptive expectations, the idea that people expect current inflation rates to continue in the future. As the price of goods and services rise, workers and others expect that prices will continue to rise in the future at a similar rate and demand more costs/wages to maintain their standard of living. Their increased wages result in higher cost of goods and services.

How inflation impacts a commoner?

Inflation impacts us in several ways:

• It increases our cost of living and dents our saving capacity.
• This is a more crucial factor in building the retirement corpus, as the expenses at the time of retirement would be significantly higher than what it is today due to inflation. • Also, over the retirement years (Life time post retirement), the income to cover the same level of expense increase (Does not remain constant) due to inflation.
• This escalation in living cost during the retirement years due to inflation must be factored in the retirement corpus that is created to fund the expenses in retirement life

The global economy is indeed an inflation-based model, where the amount of printed money is intentionally increased every year to make it decrease in value. Therefore, people are more incentivized to spend it now than save it for later, contributing to a spending economy with free-flowing cash.

But sometimes people can benefit from the unintended redistributions of inflation. Consider someone who borrows ₹ 100,000 to buy a car at a fixed interest rate of 9%. If inflation is 3% at the time the loan is made, then the loan must be repaid at a real interest rate of 6%. But if inflation rises to 9%, then the real interest rate on the loan is zero.

Let us take an example to quickly understand how inflation affects us.
To make the case more realistic, We have considered post tax returns in this example.
Mr. X holds ₹100 and wishes to buy a dress material costing ₹100. But instead of buying now, he decides to buy it after 1 year.
In this one year, he wants to earn some money from this ₹100. So, he put this money in a 1- year deposit scheme @8% interest and after 1 year gets ₹108 back.
X is in the 20% tax bracket and hence pays ₹1.6 for the ₹ 8 interest earned. He now has ₹ 106.4 as his post-tax returns.
X is happy as he now has a gain of ₹6.4, which he pockets and goes to shop to buy the same cloth material. To his surprise he finds that the same material now costs ₹109. So, he shells out his initial ₹100, interest ₹6.4 and additionally ₹2.6 from his savings pocket to get the cloth material.
Why did the prices of cloth material increase in the above example?
The prices of the cloth material has increased by ₹9 in one year. This is because the inflation rate in the economy is 9% for this one year. This inflation rate has increased the cost of the cloth material and reduced X’s buying power to the extent that he had to shell out additionally ₹2.6 from his savings.

How inflation affects our earnings and investments?

Let us see with an examples as to what extent inflation could play havoc in our earnings and investments:

Assume your current monthly expenditure is ₹30K and your age is 35. You would be retiring in 25 years from now. Then the monthly expenditure at your age of 60 would be approximately ₹1.25 Lakhs at an inflation rate of 6%. Approximately ₹2.05 Lakhs at an inflation rate of 8% and ₹3.25 Lakhs at an inflation rate of 10%. These figures are arrived by using same compound interest formula. These levels of expenses are at a time, when you retire and have zero earnings.

One argument “Our salaries are also increasing…so we are protected” This is a rosy dream. Salaries don’t increase at the rate at which the price of essential commodities increases.

TAKE AWAYS

• Inflation reduces the purchasing power, which is not visible.
• High inflation rate in the economy could washout our gains from savings and investments.
• Look for investment options which give positive post tax inflation adjusted returns (usually stocks, real estate and gold), so that our buying power isn't reduced in the long run.

That’s it for today dear reader. See you next week.

Nash Notes

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