Inflation..

Understand how and why:

I know I haven’t written anything since ages, but its better late than never. This one’s about something that affects one and all, some a little more and some a little yes. Yes, you guessed it right; I’m talking about the ugly monster, Inflation, which burns a hole in our pockets!

This financial year has been full of action with prices of everything skyrocketing and RBI constantly making a failed attempt to contain it. Inflation is hovering around 9-10% and the markets have reacted negatively (Sensex down 10-11%), perishing wealth of many. The common man has taken a beating from every corner. Let me explain the impact of high inflation on our daily lives.

Firstly, as we all know, prices of everything have gone up. From basics like onions, which were selling at Rs. 120/kg for some time, to drinking water to petrol to movie tickets, everything is costlier in comparison to the past few years.

Secondly, to contain inflation the Central bank raised interest rates, almost 8 times during this FY. Thus, money itself is expensive!

Some of you might wonder how does increasing interest rate help containing inflation and how effective is it? The answer to the first question is that higher interest rates make borrowing money costlier, because now a borrower needs to pay a higher amount as interest in comparison to earlier. This discourages many borrowers, who now find it expensive to borrow money at such high rates and thus reduces the spending. In short, it reduces demand.

How effective is the policy depends on whether inflation is caused due to supply constraints or excess demand. Supply constraints imply that the companies are not able to produce products at the same rate as the demand of those products. They are not able to produce sufficient quantity in time! Thus, in such a scenario, increasing interest rates is not of much help because it’s not solving the problem, which is of a supply constraint and not of excess demand.

If the inflation is on the rise mostly due to an excessive demand (positive outlook for a particular sector like realty or stock market or the entire economy in general), increasing rates helps to a great extent. However, at no point, any one policy alone is sufficient to control inflation.

Currently in India inflation is caused partially due to supply side constraints and partially due to excess demand. However, supply side bottlenecks are affecting inflation much more than demand factors. For example, a bad crop negatively affected the supply of onions and thus led to a tremendous increase in the prices!

Thirdly, due to high inflation and increased interest rates, stock markets have reacted negatively. Foreign institutional investors have withdrawn money from Indian stock markets due to high interest rates and inflation.

Now you may wonder why? There are several reasons for the same. Let’s take them one by one. One, inflation affects the raw material cost of companies. Cost of producing a good goes up due to an increase in inputs like labour, land, raw material, petrol, transportation, etc. Thus the profit margins of most companies reduce. To cover up for the reduced margin, companies hike prices of the goods they sell. Companies are not always able to pass on the increased cost of production onto the customer and have to thus bear a loss in profit share. This reduces the growth prospects of a company and thus its stock price reacts negatively.

Another reason for the negative reaction in the stock markets is that FII’s have withdrawn money from Indian markets. Their perception of the Asian economy has gone negative due to high inflation in almost every country. Most of the economies are interlinked with heavy dependence on imports and exports. A lot of economies have crumbled and have thus shaken the confidence in the entire region. Everyone is very cautious.

The two reasons combined have led to a negative reaction in the stock markets, due to which a lot of people have lost wealth, further aggravating the situation.