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The Inflation Beast – What is it & How is it Calculated?

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In a developing economy like India, inflation is usually a lurking challenge. On rare occasions it benefits and makes our lives happier while on most occasions it hurts us monetarily and psychologically. A key reason for this is that we fail to grasp when certain expenses transform from being luxuries to basic necessities. Today, even basic things or services require a certain amount of money which can wipe away a person’s savings in a jiffy. But what exactly is inflation? Is it just a variable? or Does it involve certain nuances which you need to understand to make informed and well-thought-out investment decisions?  Should rising or falling inflation serve as a good trigger to tweak your portfolio? Let us understand these aspects in detail:   

Inflation is a key enemy of an investor. There is no doubt about this. It silently eats into the purchasing power of an individual. Hence, it needs to be carefully monitored at all times. In India, inflation is measured in two ways: Wholesale Price Inflation (WPI) and Consumer Price Inflation (CPI). While the former accounts for inflation in wholesale prices of goods the latter accounts for retail prices of goods and services.

For beginners, it is important to understand what inflation is and how is it calculated. Only then, an investor realizes how certain clear factors affect his or her investments. Inflation is an increase in the general price level in an economy over some time. The National Statistical Office (NSO) collects data about prices in rural and urban markets spread across Indian cities and towns. Weights are assigned to goods and services and an index number is computed. Growth or shrinkage over the previous period is recorded and declared each month.

WPI comprises three groups of goods. These are Manufactured Products (65 percent of total weight), Primary Articles like food, etc. (20.1 percent), and Fuel and Power (14.9 percent). The WPI is calculated by the Ministry of Commerce and Industry. Since services cannot be consumed at the wholesale level, they have no representation in the WPI. Earlier the Reserve Bank of India used to rely on WPI for monetary policy making. However, after CY2014, for policy making, CPI became more relevant.

CPI derives price data for both goods and services. It is based on the prices of 260 goods and services. Since it tracks retail level prices, it is more relevant for the consumers. There are situations when the prices of goods change drastically at the doorstep of the consumer, compared to what they are at the wholesale market. This is especially true in times of shortage or the current situation wherein there are restrictions on the movement of goods.

Though CPI is more relevant in policy making, investors cannot take it as the Gospel truth. CPI has a 45% allocation to foods and beverages. Not many households would have almost half their expenses towards foods and beverages. Education and healthcare which have small weightages of 4.4% and 5.9% respectively may account for substantially more in the consumption basket of the household. Food inflation is a cause of concern in many periods, but it is not sticky. However, healthcare and education have demonstrated high rates of sticky inflation. Individuals must understand these nuances of inflation statistics released by the government from time to time. Instead of relying on numbers blindly, they must see why the index moved in a particular direction.

If an investor has high exposure to low yield assets–such as fixed income, then the risk is high. If the rate of inflation is higher than the rate of interest offered on a bond – technically known as the negative real yield on the bond—then investors in such bonds lose their purchasing power over a period, if the inflation remains at a high level. Taxes further bring down the net yield in the hands of investors.

Today, inflation is high. A situation has developed which has created high inflation. Factors such as unprecedented money-printing and infusion of liquidity in financial markets across the world have led to high commodity prices. This has led to high inflation in developed markets. For example, the US consumer prices jumped 4.2% in the 12 months to April 2021, up from 2.6% in March. This is the biggest increase since September 2008. This situation is expected to transpire across the globe as the same factors are contributing to rising inflation in other countries also. Given these factors, investors must realign their portfolios to protect their purchasing power. Their investments will fare better in the long-term if they diversify their investments across asset classes such as equities, real estate, and gold. Such diversification will help investors beat inflation to a considerable extent.

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