FAQ: How inflation affects our ability to manage money

In this FAQ aimed at beginners, we discuss the role of inflation in personal finance.

This is written for laymen by a layman. An academically precise account of inflation taking into all factors responsible is beyond our scope.

1: What is inflation? Inflation is the general rise in prices in prices over time Just like a stock price it depends on various factors and the rate of growth or decline in inflation fluctuates quite a bit. Inflation is a necessary evil. Too much of it is bad; Too little of it is bad. Even developed countries like the US have struggled to contain inflation as recent as the late 70s and early 80s.

Also, see:

• Inflation in India: Some Real Numbers
• Inflation has reduced Rs. one lakh to just Rs. 6000 in 40 years!

2: Why does inflation occur? The root cause of inflation is due to the way we live. Consumerism is now the foundation of our economy and existence. Some of us create goods and services and others consume them. The rate of production will never always be equal to the rate of consumption (Japan is an exception).

A mismatch between demand for goods and services and their supply will result in price changes (increase or decrease) and hence inflation or deflation. If demand exceeds supply, a price increase prevents goods from getting exhausted. A shortage in supply due to natural factors like drought, floods or some kind of global event can also result in a price increase.

In normal situations a gradual increase in demand (due to an increase in population for example) and a gradual increase in production costs to keep up with demand and desire to profit more results in a gradual price increase.

It must be kept in mind that each product and each raw material that goes to creating it has its own supply vs demand tug-o-war. For example, a petrol price increase may contribute to a price increase of a product but a drop in raw material price (eg. metal or cotton) can offset the effect. So it is an extremely complex situation with multiple factors in play.

Also, see:

• Inflation in India: Will it ever decrease?

3: Why is a little inflation good?!

If prices keep increasing, we will buy stuff now rather than later when they are likely to cost more. So this keeps demand at a healthy level. Supplies there have an incentive to produce more goods and offer services. They will need to borrow money to keep with the demand and they will have to hire people.

Population growth is also an important factor. Japan’s population has barely changed in the last decade and its GDP has been oscillating up and down since the 1990s. Source: Datacommons. Since there is not much growth in demand, inflation has been close to zero in Japan for decades.

This means the rate of profit growth for supplies is low and the stock prices reflect this. People don’t need the stock market as the money supply is high. So stock prices do not move up. This means they can beat inflation by just keeping money under the mattress.

Many people wonder what if a Japan-like situation occurs in the Indian stock market. It can, but we are a long way away from that. Our population and our GDP are still growing at a brisk pace.

So a small amount of inflation will keep the economy moving in the right direction. What this small amount is, will depend on the economy. For the US it is 2%. For India, it is about 4-6%.

There are two opposites of “good inflation”

Deflation: When prices keep falling and people wait to buy at a lower price it reduced the money in circulation. This would result in production stoppage and unemployment. To discourage saving interest rates are decreased. If the deflation continues then interest rates become negative (we lose money when we save).

Hyperinflation: Sometimes there is a slump in economic growth even when there is a strong demand. Then prices of goods and services spiral upward.

4:What is the relationship between inflation and interest rates?

When the rate of borrowing is low and there is a reasonable demand, suppliers look to borrow and increase production Employment levels are good. Consumers can also borrow with ease and buy. If the demand is a bit higher than production (say due to population increase), it will result in a small increase in prices or good inflation.

When the rate of borrowing increases, consumers would rather save than spend. Suppliers would then maintain/reduce production instead of trying to increase it. This means prices will fall as demand falls. Inflation decreases and the economy slows down.

So typically there is an inverse relationship between interest rates and “good inflation”.  If inflation increases higher than what is considered healthy, then this relationship breaks down and interest rates will have to increase too.

This is because if I am going to lend money at a time when inflation is high, I will demand higher payment (interest rate) because the purchasing power of money is falling fast. This holds for banks providing loans or the common man investing in bank FDs or govt bonds.

This is a dangerous situation and if it prevails for long can derail the economy and even result in hyperinflation. Our neighbours Pakistan and Srilanka are currently going through such a situation. See: Sri Lanka on brink of a sovereign bond default, warn investors.

India was in a similar state in the early 90s and was forced to open its economy. That 12% PPF interest rate in the 90s was no joy ride. That was a government struggling to pay its debt – a few steps away from hyperinflation. Counterintuitive as it may seem, we expect more interest from a person who finds it hard to pay!

5: Why high-interest rates are not good!

Many of us tend to be happy if interest rates increase. An occasional increase is normal. If rates stay high and keep increasing it will result in unemployment or lower salaries because economic growth has weakened. There is lesser money to spend and therefore lesser money to save.

Once we embrace capitalism, we will have to dance to its tunes and get rid of our socialist (govt will save us) leanings. The govt has to save itself first. Sometimes it works in our favour and sometimes not. The wheels of consumerism once set in motion can neither be stopped nor altered.

6: Why do people talk about “beating inflation”?

Over time the price of goods and services increase. If they increase at a rate higher than the rate of return on our investments then we cannot maintain our current lifestyle when we retire. This is why we must do two things: (1) invest our money for long term needs and not just save it. That is to take on capital market risk so that there is a chance of getting a return better than inflation. (2) We must also invest enough.

7: why do people say equity has the power to beat inflation?

For a company to be in business it must generate a profit higher than its debt. Assuming the rate of debt reflects inflation, the rate of profit must be higher for the company to stay in business.

A single company may or may not stand the test of time but a basket of stocks put together by say, their market capitalization has a much better growing at a pace higher than inflation. Simple examples of this are the Nifty or the Sensex.

For some data, see:  Why should I invest in equity mutual funds when there is no guarantee of returns?

To understand why investing enough with low return expectations is important see: Equity may beat inflation but that doesn’t mean you will!

You can beat inflation with money too! Just that it is not practical. See: There is more to investing than just getting high returns!

8: Is inflation not important for short term goals?

Inflation does matter for short term goals but we cannot take risks and try to beat it as there is not enough time to recover from losses. Instead, we choose less volatile, less risky products and compensate for investment by investing a bit more.

9: What inflation should I use while planning for retirement?

We recommend at least 6% and at most 8%. See an illustration here: I am 30 and wish to retire by 50 how should I plan my investments?

10: What inflation should I use while planning for my child’s future?

We recommend using at least 10%, preferably a bit higher if you can afford the higher investment.

11: What is lifestyle inflation?

In addition to the price of essential expenses increasing over time, our lifestyle also becomes more expensive as our income grows. For example, paying for multiple OTT platforms; buying more expensive smartphones etc. With time these also become essential expenses.

This is why we recommend reviewing “what is an essential expense?” once a year and updating our retirement planning calculations. If the rate at which our expenses increase match the rate at which our income grows it is a sign of trouble. We need to go easy with the purchases!