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>> NOVEMBER 3, 2003
Inflation: A perspective
MYSTOCKS | FREE NEWSLETTER
"Inflation is when you pay fifteen dollars for the ten dollar haircut you used to get for five dollars when you had hair," said someone, very rightly! Well! Despite being one of the most 'misunderstood' terms in economics, it is one of the most talked about. However, the importance of understanding what inflation is all about and the causes and effects of inflation can clarify most doubts regarding this much-discussed topic. In this write-up, we discuss about inflation with respect to the Indian economy and see how it has affected our lives in the past. And in that process, we would also touch upon interest rates, which are determined by, the supply and demand of money in the economy that, in turn, determines inflation, ceteris paribus (other things remaining constant).
What exactly is inflation?
Simply put, inflation is a general increase in prices across the economy over a period of time. Two popular ways of measuring inflation are based on the changes in the Wholesale Price Index (WPI) and the Consumer Price Index (CPI) over a period of time. The WPI is a measure of changes in price charged by manufacturers and wholesalers. Simply put, it measures the changes in commodity prices at a selected stage or stages before goods reach the retail level. CPI, on the other hand, is a measure of the average change in prices over time in a market basket of goods and services. Whether to use CPI or WPI as the basis for inflation depends on the economic policy of a particular country. In India, the term 'inflation' generally means the WPI.
And what is the optimum level?
Inflation is bad at both high and low levels. A high level of inflation negatively impacts both businesses and individuals. While businesses lose their cost competitiveness due to higher input costs and demand for higher wages by workers, uncertainty regarding the future makes planning difficult. On the other hand, individuals are affected because of the fact that the real value of their savings and returns from investments (especially from fixed return investments) diminish. However, there is one class that benefits from high inflation. These are the borrowers whose real value of debt declines. And in the Indian context, the government (due to its large borrowings) is the biggest beneficiary of this effect of high inflation.
A very low level of inflation too has negative effects. It increases the chances of the economy moving towards deflation, i.e., falling prices. And as consumers postpone their purchases in the hope that prices would fall further, the resultant effect is witnessed in falling levels of output as industries cut back their production.
Considering these facts, and many more, the Reserve Bank Of India (RBI) has come out with an optimum level of inflation (based on WPI), at 5%. And, we believe, this is one of the important bases for the RBI's monetary announcements. While the RBI still does not follow the practice of inflation targeting (whereby monetary adjustments are made to target a particular rate of inflation), most of its decisions regarding liquidity levels and interest rates hover around maintaining price stability, employment generation and availability of credit in the economy.
Unlike other countries, inflation in India is generally based on the WPI. In early days of our independence, i.e., through the 1950s and 1960s, inflation based on the WPI remained well below the 7% level. Later, while it increased in the first half of 1970s, the movement was reversed in the second half of that decade and through the 1980s. Later, four out of the first five years of the previous decade (the 1990s) registered double-digit inflation, with almost a 14% peak reached during 1992-93. Since then (the second half of 1990s), inflation has been on a continuous decelerating trend. In fact, the average WPI inflation for the period between 1996-97 and 2000-03 is the lowest since the mid-1950s. And, especially during these later years, the RBI has had a major role in maintaining inflation rates at comfortable levels.
That was about WPI inflation. However, to relate inflation levels in India to those prevalent in the other regions of the globe, CPI inflation would be a better indicator as most of the economies from the developing and the developed world use this measure as an indicator of inflation. The graph above is indicative of the relative comparison of inflation rates (measured as consumer price index) in different regions of the world. While there has been hue and cry about the developed world (like the US and EU) moving towards the 'depressing' situation of deflation, India can boast of the fact that the country's central bank, the RBI, has managed to keep inflation at 'comfortable' levels. And this, the RBI has managed to do through the use of the most 'lethal' instruments at its disposal – the bank rate or the repo rate.
…and interest rates
As the time for announcement of the mid-term review of the monetary policy for 2003-04 nears, all heads are turning to see what Dr. Reddy (in his maiden policy announcement) will do to interest rates, now when inflation is hovering around the 'comfortable' level of 5% and the overall prospects of the Indian economy looking good like never before. Over the past few years, the RBI has adopted a soft interest rate regime to propel growth, and one cannot deny the objectivity of the policies adopted in this regard that have helped the Indian economy (read India Inc.). This soft interest rate regime has helped the Indian industry clean its books of high-cost debt, and as a result, give a boost to its overall profitability. Finally, this has gone a way in improving the global competitiveness of Indian companies helping India to move ahead in its pursuit of the 1% global trade share target.
Another beneficiary of this soft interest rate regime has been the Indian government, the largest borrower from the financial system in the country. While the proponents of high fiscal deficit vote for lower interest rates as this helps the government in borrowing extensively to meet its infrastructure (and other) spending, there is a case against this as well. It says that as government's ability to borrow more to meet its expenditure demand increases, this might lead to higher inflation in the economy (as government borrowings lead to rise in money stock). However, if this had been the case, then the inflation levels in India would have been rising by leaps and bounds, which, in fact has not been the case. This is because as government spending increases, output levels in the economy also rise to match increased demand as spending power increases.
Now, while this soft interest rate regime has helped India Inc. to improve its operation efficiencies, and the government to spend more towards the growth of the country, there is one section that has been at loss – the small investor. Small investors who have been investing their lifetime of earnings into risk-free fixed income securities have borne the double whammy of reduced interest rates on their investments on one hand and, on the other, the reduction in their real returns due to inflation propelled by this soft interest situation (read article ). Thus, it would be the small investor who would be looking forward to the new governor's stance on interest rates, as this would determine his savings and (real) returns on his investments.
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