scorecardresearchWhat is inflation and why does it harm? An explainer

What is inflation and why does it harm? An explainer

Updated: 02 Dec 2022, 01:26 PM IST

Inflation is the rate ( in percentage terms ) at which a product or service moves up or down, over time. Read further to know more

Inflation moves up or down for a product. Most people do not accept that inflation can move down.

Inflation moves up or down for a product. Most people do not accept that inflation can move down.

Inflation is a dreaded word for most people. It signifies loss of purchasing power, high prices, more spending and less money to go around.

What is inflation?

Inflation is the rate (in percentage terms) at which a product or service moves up or down, over time. However, many people do not understand this.

People talk of high prices and inflation in the same breath. High price is a rupee amount, which can be the result of inflation over time. Inflation itself is the rate of change of the price of a product or service over a period (say, a year).

Inflation moves up or down for a product. Most people do not accept that inflation can move down. If the prices of pulses move from Rs.175 to Rs.160 per kg, it is a downward movement of inflation. But, many people point out that the price is still high (which is true) and do not accept that inflation is negative. In the case of milk, if the price remains at say Rs.50 to a litre for a year, the inflation is zero. But people still talk about prices being high due to inflation, which are two different things!

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Is inflation bad?

But is inflation really negative? That is what we all have been told. But, it need not be.

Let us imagine a situation where there is moderate inflation like, say, 5% pa. We know that the good/ service will be costlier by that factor in the future. Hence, it impels us to buy now if the item is needed.

If the inflation is very high like, say, 12% pa, then people may panic and start hoarding. This is not a great thing as it can create an artificial scarcity in the economy and send the prices soaring even higher.

If the inflation is nil, there is no incentive to buy the goods now. We will tend to postpone the purchase till the last moment.

If the inflation is negative like, say, -1% pa, there is no incentive to buy at all now as the same will be available cheaper in the future. It is hard for us to imagine negative inflation. But it happens with commodities all the time. As an example, a vegetable that sells for Rs.80 a kilo drops to Rs.30 a kilo after a few weeks.

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Effect of inflation

A low to moderate inflation is not a bad thing and impels people to buy rather than postpone it for a later time. This is indeed what most economies want to have, as economic activity will proceed in a healthy manner.

If there is a high inflation, customers turn cautious on discretionary items as they are worried about the future. They spend just enough to get by. On the items that are essential (like groceries, consumables etc.), they tend to panic and stock more, creating an unwanted scarcity that jacks up the prices more.

This affects the businesses in terms of lower business done. This again makes businesses increase prices to earn as much as they used to in the past, which further fuels the inflation and makes clients even more reluctant to spend.

In a high inflation scenario, the cost of capital also tends to be high. With soaring prices, they are unsure whether clients will continue to patronise them. Hence, businesses will not invest more in the business, which brings down the growth.

In a nil or negative inflation scenario, there is less incentive to buy now. If the inflation is negative, it makes sense to buy in the future as it will be cheaper then. This is very tough for businesses as buying decisions keep getting postponed and businesses become anaemic.

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Different products have different inflation trajectories

Different commodities and products have different inflation trajectories. That is why, Consumer Price Inflation (CPI) is determined by the overall inflation of a basket of commodities which is indicative of what normal consumers buy.

People consume a plethora of products and services to different extent. Hence, the effect of inflation on different people is bound to be different. For instance, someone who has school going children will be more concerned about education inflation. Another who has a long commute to office will worry about fuel inflation. Hence the effect of inflation on different people is different based on what they consume and the extent of their spending on that item.

Inflation & interest rates

Normally, the interest rate should be higher than inflation giving an incentive to investors to earn a real return after factoring inflation. So, in a high interest rate scenario, the interest rates should be ideally higher than prevailing inflation. But, it is not always so.

High interest rates make credit costlier for the businesses and bring down economic growth. Hence, interest rate levers have to be carefully handled. RBI manages money supply in the economy and controls inflation and uses interest rate in the system as one of the tools.

In the other situation, when the returns from investments are lower than the inflation, there is no incentive to save and consumers may rather want to spend the money. But that can again further fuel the inflation.

In a moderate inflation scenario, people buy what they want now, instead of postponing. Also, with interest rates that are slightly higher than inflation, they have an incentive to invest too.

In conclusion, inflation by itself is not bad. In fact, moderate inflation may even be desirable. It is very high or very low inflation that is a red herring.

Suresh Sadagopan is the MD & Principal Officer at Ladder7 Wealth Planners and is the author of the book If God was your Financial Planner

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First Published: 02 Dec 2022, 01:26 PM IST