Rising inflation is one of the biggest stories of recent weeks and has received a great deal of attention from the media and political parties. At the same time inflation is an economic problem that the average person meets on a daily basis in terms of higher prices particularly of food products.
In this article we will take a look at some of the basics about inflation.
How is inflation measured?
In India there are two broad measures of inflation: the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). Of the two the latter has a higher profile because it is measured more frequently, that is, every week. When you read about inflation rising to 7 per cent in the newspaper it's probably referring to the WPI.
The WPI is based on the wholesale prices of 435 items ranging from agricultural commodities like wheat, rice, groundnuts etc to manufactured products like steel, cement etc. A single index number is calculated based on those prices and the inflation rate is calculated by comparing the most recent index number with that of a year ago.
Why are prices rising?
A number of factors, actually, many of them global in nature but the chief among them is the rise in the price of oil above $100 per barrel. Petroleum is used to make fertilizer and also as fuel in transportation so naturally when oil prices rise it affects food and other prices as well.
Strong growth in big, developing countries like China and India has also contributed to inflation by boosting demand for many commodities like cement and steel. Finally weather-related problems have reduced agricultural output in some countries like Australia further putting an upward pressure on the price of wheat.
What is the government going to do about inflation?
Inflation is a major political concern for the government because of upcoming state elections and a general election soon afterwards. Inflation and rising food prices in particular tend to hurt the masses the most and therefore is a major issue at election time.
The bottom line is that we can expect a range of policy measures to fight inflation.
The government has already taken some quick steps like trying to curb exports in sensitive commodities and reduce the cost of imports. The idea is that exports reduce domestic supply adding to the pressure on prices; therefore the government has already banned the export of cement and non-basmati rice and may ban other commodity exports later.
Similarly cheaper imports help keep prices low and the government has reduced import duties on edible oils as well.
Further action may be taken by the RBI: for example raising interest rates which will reduce liquidity money floating in the system -- and the total demand in the economy which will reduce the pressure on prices.
Another option is to allow the exchange rate to appreciate (let rupee rise in value against the US dollar). If the rupee rises in value, imports will become less expensive which will help moderate inflation further.
Adjusting for inflation
It's important to learn how to adjust for inflation when evaluating the rate of return on an investment.
For example suppose you put your money in a one year fixed deposit which pays a return of 8 per cent. If inflation is around 7 per cent for the year, your inflation-adjusted return is just 1 per cent (8 - 7). Similarly if your salary rises by 5 per cent and inflation is 7 per cent your inflation-adjusted salary has actually fallen by 2 per cent (5-7).
Inflation and investing
You may have to modify your investment strategy in order to cope with inflation. Generally speaking commodities including gold are considered a good hedge against inflation as also are stocks. Investments that should be avoided are long-term fixed deposits whose inflation-adjusted value may be seriously eroded if inflation remains high.
Is inflation affecting you? How?
Is the recent increase in prices of essential goods of daily use affecting you? By how much have your monthly budgets increased compared to what you spent last March-April?
Have you stopped/reduced the number of social outings in a month with your friends/family/spouse/partner because it costs you more now?
How are you investing to maximise your returns in the times of high inflation?
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