Sarika Joshi was shocked when price for one kilo of onions jumped from Rs 10 to Rs 14 in a span of two months. It was a 40% jump in a vegetable that she used in almost every meal.
The price of other things she brought on a regular basis had increased as well. The price of her toothpaste, her lipstick, her sandals, her grocery bills were all going through the roof and there was nothing she could do about it.
Though she got a 10% salary hike in 2006, she was finding it difficult to manage her household budget in 2007. She could not buy the same amount of things with Rs 100 this year that she bought in 2006.
She realised that the value of Rs 100 in her wallet was not the same as it was the previous year. Simply put, Sarika's purchasing power had decreased.
This decrease in an individual's purchasing power is what economists call inflation. Inflation, or the rate at which general prices increase in an economy, is what all central banks in the world dread.
Higher inflation = greater heartburn
Let us see how inflation eats into your savings or returns from other investments you have made for the long term.
Let's say you have deposited Rs 100 in a one-year fixed deposit scheme at 10% interest per annum. At the end of one year, you will get Rs 110 -- this includes the principal (Rs 100) and the interest (Rs 10).
You might be surprised to learn that the 10% return you earned on your investment is not the return you actually get. Your actual return is calculated by taking reducing the impact of inflation on this 10% return -- in this case, Rs 10.
The 10% return that you get on your FD is the nominal rate of return. Once you deduct the inflation rate from this nominal rate what you get is the real rate of return. And this is what should really matter to you as an investor.
Assuming an inflation rate of 5%, your real rate of return would turn out to be only 5%, that is nominal rate inflation rate = real rate of return. So the Rs 110 that you will get will be able to buy goods only worth Rs 105 when your FD matures after a year.
In other words, a pair of sneakers that you bought for Rs 100 this year may cost your Rs 108 next year, if inflation rate then is 8%. However, if the inflation rate is, say, only 2% in 2008 then the same pair will cost you Rs 102.
Remember. Higher the rate of inflation greater is the heartburn.
It is exactly for this reason that governments and central banks (in India it is the job of the Reserve Bank of India (RBI) to control inflation by adopting various tools at its disposal) all over the world to tame inflation).
Different economies are comfortable with different levels of inflation rate. If the RBI is comfortable with an inflation rate of 5.5% then the US central bank, the US Federal Reserve, is comfortable with only 2% inflation rate. Most developed countries like the US, the UK, Germany, France, Italy and Japan have low tolerance towards inflation.
Demand-pull inflation
We all know that demand for a particular good/service and its supply determine the cost or price of that good/service. Price of say a kilo of rice is decided only when the buyer and seller agree at a price. This is known as equilibrium, a state where demand and supply meet each other at an agreeable price.
Let's assume that there are 10 people and each one of them is demanding a computer. The computer manufacturer produces only 10 computers and each one of them gets a computer for the price quoted by the producer, say, Rs 40,000.
Now assume a scenario in which the same set of 10 people demand two computers each. However, due to some reason the producer manufactures only 10 computers leading to a shortfall of 10 computers.
Here the demand has increased without an equal increase in supply leading to disequilibrium (a state where demand and supply don't meet). Obviously, as each person is desperate to buy two computers they will outbid each other.
Each one of them will quote a price higher than the other to meet their own demand. The highest bidder in this case will get the two computers needed by him. Let us say that the highest bidder quoted Rs 50,000 for the computer for which he had earlier paid Rs 10,000 less.
Once the producer realises that buyers would pay him any price to meet their requirements, s/he will start demanding Rs 10,000 (or any such amount that he thinks the buyers will pay) more for the remaining eight computers.
In this case, it was demand for computers that led to an increase in prices or eroded the purchasing power of the buyer. This is demand-pull inflation.
It is because of demand-pull inflation that the cost of your interest rate for buying homes is increasing. More people are demanding money to buy a house (loan) and limited money available in the banking system.
Cost-push inflation
Say you are a computer producer and you assemble different parts required to make a computer. This includes motherboards and various chips and integrated circuits. Assuming that you have a fixed amount of Rs 1,00,000 to run your business and you manage to make 4 computers out of this amount. In this case cost of each computer will be Rs 25,000.
Now imagine a situation wherein the prices of the inputs like motherboards and integrated chips increase by 100% and you are able to make only two computers out of the money that you have.
In this changed circumstances you are able to make only two computers, instead of the earlier four, at Rs 50,000 each. Will you now sell them at the earlier price plus your profits?
Your cost of production has increased and to protect your own profits you will sell these two computers now at more than Rs 50,000 a piece. Imagine a buyer who'd earlier got the same computer for a little over Rs 25,000 paying Rs 50,000 for the same thing.
In this case, the cost of production has led to an increase in the cost of computers. This is cost-push inflation.
The recent increase in prices of soaps, detergents, toothpastes and other fast moving consumer goods are attributed to cost-push inflation. The inputs used to make soaps and detergents are derived from crude oil. As the prices of crude have been on an upward spiral recently the cost of production of these inputs too have increased.
The manufacturers like HLL and Proctor & Gamble, for instance, have passed this increase in their cost of production to the ultimate consumer that is you.
The index of inflation
In India, the inflation data is announced every Friday at around noontime. While most newspapers have it the next day, business channels and Internet websites is where you can get your dose of inflation on Friday itself.
In India, inflation is measured by two different indices based on the consuming category.
Inflation that affects wholesalers is called as the Wholesale Price Index or WPI and inflation that affects consumers is called as Consumer Price Index or CPI.
Strangely, though, the inflation rate that we get every Friday is WPI and not CPI. WPI is the benchmark inflation index in India.
WPI is of no use to us as it reflects the change in prices of goods/services for wholesalers and not consumers.
The inflation as of now for the week ending (this index is calculated weekly) January 19 (the figures are announced with a time lag of two weeks as collating data that is representative of the entire Indian economy takes time) is 6.11%, much above the RBI's comfort level of 5.5%.
Again this inflation is a year-on-year (YoY) figure. What this means is a good/service that cost you Rs 100 on January 19, 2006 cost you Rs 106.11 on January 19, 2007.
This impact of inflation is true for all the goods and services that you avail of. Remember again, higher the inflation greater is the heartburn for you.
