A-Z of Investing: Inflation

I'm planning to write a series of short articles on some of the commonly used terms in investing. These terms may seem obvious to most, but in reality they are not clearly understood by many. Usually, it is these terms which confuses the ordinary investor. If these terms are well understood, I'm sure the investors will be in a much better position to make sense of investing.

I'll start this series with probably the most loosely used term in today's times: Inflation!

What is inflation? I'm sure that most people will be able to answer that in a sentence. "Inflation is a rise in the overall price levels of goods over a period of time." So for example, if a kilo of sugar was Rs. 25 a few months back and it's now Rs. 30 - that's an example of inflation in daily life.

Ok, so that much is almost common, accepted wisdom.

What needs to be understood is the cause for these price rise. Who is responsible for the increase in prices? Is it a co-ordinated effort by all producers? Is it an impact of global conditions? What is the RBI's role in it? And where does the media pull up the these fluctuating inflation rates?

Inflation is mostly caused by an increase in demand or a decrease in supply or a combination of both. Such situations lead to more money chasing fewer goods in the economy. For example when the monsoon fails, there is a shortage of food grains and other crops which are essential parts of our daily life. This sudden decrease in supply causes prices to rise. This has happened in the past and it will happen in the future.

But look at the current scenario. India is going through a period of high economic growth (more money with people than before) and at the same time, there was major crop failures in many parts of India. That's a combination of great demand and lesser than usual supply - definitely a recipe for a serious price rise. No wonder we saw high inflation rates during the last one year.

If inflation is a rise in prices, inflation rate is a way to capture this increase in terms of a number. In India, inflation is calculated on the basis of the Wholesale Price Index. This index is based on the wholesale price of 435 essential items. The rate of inflation is the increase/decrease in the price levels of these 435 items during a period of time. For example, if the price of these 435 items was Rs. 100 on August 1, 2008 and the same set of 435 items cost Rs. 108 on August 1, 2009, then we say the rate of inflation for August is 8%. Note that not all 435 items are given the same importance. Each item has a particular weight based on its importance. So something like sugar - which is an essential part of our diet has more weight than something like shoes. So a rise in sugar prices will cause the inflation rate to move higher than a similar rise in footwear.

Overall, the WPI consists of three types of items:
1) Manufactured goods which has a weight of 63.75%
2) Primary items like foodgrains and edile oil - 22.02%
3) Fuel, light and lubricants which add up to 14.23%

Is this the best way to calculate inflation? Is it accurate enough?

There is lot of debate on whether WPI is the best way to go. We use WPI method because we have ready data for it. The other option is Consumer Price Index (CPI) which is more accurate from a consumer's point of view, but unfortunately, we don't get the data early enough to compute it as easily we can with WPI. The following are some shortcomings of the WPI method of calculating inflation:

1) It is calculated on 435 items. But as consumers it's not just the price of items that matter to us. We also pay for services which constitute a major part of our expenses. By not considering the cost of services, the inflation rate gives an incomplete picture.
2) Most countries (around 160) calculate inflation on Consumer Price Index - the price that the consumer is paying to the market. In India, it is calculated at the wholesale price -which is not the price that we end up paying (we pay quite a higher amount when the products reach us).

But demand and supply is not the only cause for inflation. The amount of money in the economy also has an effect on inflation. That's where the government and the RBI come in. The RBI regulates the amount of money that is available by controlling the interest rates and the amount of money that banks can lend. When interest rates are high, people will borrow less, spend less and invest more. This ensures that less money is chasing goods - so price of goods could come down. This basically affects the demand-supply by causing demand to lessen - thus making supply equal or greater than the demand. So prices of those items will drop down automatically. Similarly, by asking banks to lend only a certain part of the money they have, they reduce the money that is available for loans, etc. For example, if banks cannot extend loans to people, the demand for houses will drop - thereby reducing the price of houses. Which will in turn reduce the price for cement and steel, etc. So overall, consumption drops.

That was a short and quick explanation of inflation and how it works. This understanding should give a fair idea of what's happening when inflation rate increases or decreases. The interested investor can explore deeper into the subject if required. Any feedback on this post will be welcome.