Inflation Explained: What is Inflation and how to beat it effectively?
Last Updated on November 29, 2021 by Chitale CFS Pvt Ltd
Inflation can be defined as an increase in the price of goods and services in the economy.
Inflation means that your purchasing power is constantly decreasing and your money today is not able to buy as much as it did yesterday.
The Goverment’s as well as Reserve Banks’s monetary and fiscal policies are intended to contain inflation. However, one should never depend on such policies and have a concrete financial plan in place to safeguard oneself against the increasing inflation rates.
What is inflation?
In its most basic form, inflation definition can be put as the loss of buying power of money over time. You’ve probably realized that things are more expensive now than they were 10 or 20 years ago. As prices increase, a given sum of money buys less.
Inflation is described as an increase in the cost of most everyday or basic goods and services, such as groceries, apparels, housing, entertainment, transportation, commodities, and so on. Inflation is defined as the average change in the price of a set of goods and services over time.
The level of inflation or inflation rate varies from year to year and is assessed by wider financial variables, including lending rates set by the Reserve Bank.
The average rate of inflation in India is estimated to be 2-3 percent for financial management purposes. So t o retain your desired life, you’ll need to raise your earnings by at minimum 3 per cent per year to cope up with the inflation as well as find ways to invest funds that generate more than 3% interest.
For example, if you don’t invest your Rs 100 today, it will only be worth Rs 94 after a year if we consider an inflation rate of 8%. As a result, one must always be on the search for investments a with higher returns than that of the current inflation rate.
What are the effects of inflation
When goods and services become cheaper, the purchasing power of currency units declines. The cost of living is also affected. If inflation is high, the cost of living will also be higher, resulting in the economic growth eventually decelerating. In order to encourage spending and reduce savings by stockpiling money, a certain degree of inflation is needed in the financial system.
Both people and the economies are affected by inflation. When inflation grows more quickly than incomes, it triggers a decline in buying power that ultimately forces citizens to cut down expenses, buying supplies covering groceries, foodstuffs and clothes to healthcare services.
Many investors could suffer losses in financial market as an effect of inflation. Reserve bank often alters short-term interest rates to sustain the target inflation rate.
How is inflation measured?
In India, inflation is predominantly calculated by two indices: the WPI (Wholesale Price Index) which represents changes in wholesale prices and the CPI (Consumer Price Index), which represents changes in retail prices.
The WPI measures the inflation for products and services provided by bigger companies to smaller businesses for further reselling.
The CPI, on the other hand, measures the price difference between goods and services such as food, healthcare, education, and appliances that Indian customers buy for personal use. The CPI is a commonly used metric for determining whether an economy is experiencing inflation or deflation. In 2013, the Consumer Price Index (CPI) superseded the Wholesale Price Index (WPI) as a scale to measure the inflation rate in India.
What are the causes of Inflation?
There have been extensive studies and discussions about the leading causes of inflation in India. These are some of the key factors for price growth:
Higher demand and lower output or multiple commodity supply create a shortfall, leading to an increase in prices.
Excess cash flow contributes to inflation when money loses its buying power.
People prefer to spend more because they have excessive money, which creates more pressure on supply.
What are the types of Inflation
Three major types of inflation are believed to account for this rise in the prices of products and services across the financial system: built-in inflation, demand-pull inflation and cost-push inflation
Presumption of inflation rates in future results in built-in Inflation. The increase in the prices of products and services leads to rise in the wages so that people can afford the rising cost of living. As a consequence, higher wages raise the cost of manufacturing, which ultimately affects the product prices. Thus, the loop begins.
With demand-pull inflation, the demand for goods and services exceeds the system’s capacity to generate them, putting immense pressure on prices resulting in inflation.
Cost-push inflation occurs when the price of raw goods and services rises, thus raising the price of finished products and resulting in inflation. For instance , an oil crisis often leads to a drop in the supply of oil and a rise in the value of petroleum. The rising price of crude oil exerts immense pressure on the prices of petroleum products and services, resulting in a brief spike in inflation.
What is deflation?
Declining prices in all or most sectors of the economy result in deflation. While that might seem to be good in the short term, in the long term, unregulated inflation is much worse.
People hold off buying when prices drop because they anticipate lower prices to follow. If allowed to continue, deflation will weaken or halt the growth in the economy, which as a consequence destroys employment and cripples the economy.
Deflation can negatively affect businesses and the economy in the same way as price inflation. Deflation is also correlated with less consumer spending, which can cause businesses to take cost-cutting steps that can raise the rate of unemployment.
Can Saving account beat inflation?
Saving accounts alone cannot protect you from financial loss arising from inflation. That is because the majority of saving methods, such as savings bank accounts or PPFs, do not reliably outperform inflation over a long period of time. As a result, investing in them can enhance the portfolio, but the buying power of your money will be diminished in future.
While a simple savings account is an excellent way of saving money with easy liquidity, but even the top savings accounts often pay less than 3-4% interest which ensures your savings will not outperform inflation.
We always recommend that everyone should try to save at least three to six months’ of living costs as an emergency fund in a standard savings or money market account, but to fight inflation, you’ll need higher-yielding assets.
How to beat inflation:
Even with a modest inflation rate, money kept in cash or in a low-interest saving bank accounts would eventually lose its buying power. There are many ways of investing in diverse assets to beat the inflation; some of the investment avenues to beat inflation and increase your money’s purchasing power are as follows:
Beat inflation with Mutual Funds
Making investments in stocks over a long period of time is one of the most effective strategies for beating inflation. Over the last decade, the Nifty has generated over 15% returns a year as compared to a 6-7% inflation rate. One can either purchase shares directly or through mutual funds investments. For small investors, it is prudent to invest via mutual funds, which are professionally managed.
Investors who are looking for higher risk-adjusted returns should consider equity mutual fund plans that are diversified. That being said, investment in equity mutual funds should have a minimum time period of three years, if not longer. Another way to mitigate risk is to invest in systematic investment plan or SIP. The compounding effect of these kinds of investments over time will allow you to comfortably outperform inflation.
Mutual funds are usually the best investment option for the entry level investors who are primarily looking to beat inflation. Equity mutual funds typically have higher long-term gains than the average rate of inflation.
Allocation of assets is important to beat inflation. One way to approach this is to see it as an option to diversify widely. This would result in a more balanced portfolio that is less susceptible to market instability and inflation.
Diversified investment strategies mitigate risk by distributing it across a diverse range of portfolios, segments, sectors, and financial instruments. Many investors believe that by splitting their funds across several mutual funds, they can have a sufficiently balanced portfolio. However, distinct does not necessarily imply diversification. Diversification means you need to expose your investments to a variety of mutual fund products.
In addition to this, while choosing the right mutual fund scheme, we always recommend investors to carefully compare direct vs regular mutual fund schemes.
If you invest in mutual funds through regular mutual fund plans, mutual fund distributors like Chitale CFS Pvt Ltd, who have years of experience in mutual fund investments, can help you to select most relevant schemes so that you can beat investment in long run. However, if you choose the direct mutual fund plan, you will need to put your own time and efforts to make investment decisions.
Beat Inflation with Gold:
Gold is regarded as an effective hedge against inflation in India. But gold should account for a limited portion of your portfolio.
Investing in Gold has been conventionally considered as a measure of wealth and has often served as a shield against inflation. And, at a time when inflation is being viewed as a threat, gold provides additional layer of protection against the inflation. Gold has always provided inflation-beating yield.
Beat Inflation with Stock:
Investing in the share market is another way to effectively beat inflation. Although particular stock prices may drop or private firms may go out of business, and bear markets may even disrupt indices temporarily, larger stock market indexes tend to outperform inflation over the longer time frames.
For stock investments, a medium or longer duration investment timeline is advantageous, and equities must be chosen on the basis of solid fundamentals, growth potential, and financial strength. However if you compare mutual funds vs stock market, mutual funds are always better option for average investors.
An inflation calculator estimates the value of a given amount of money after a specified time span.
You can use this inflation calculator to know the future value of any products of services in future and you can plan your investments according so that you will understand how much money you will need to buy that product or service during a particular time in future.
For example, you can plan your financial goals like child’s education or build your retirement corpus by checking the future cost of living.
To summarize, in order to beat inflation, it is worthwhile to focus on investment instruments that will outperform inflation over time.
The primary reason for goal based investment planning is to ensure that one can continue to live comfortably in the future, despite a rise in the cost of living due to inflation.
To do this, investors must invest in a manner that enables them to gain inflation-beating profits. However, these assets carry a higher risk than traditional savings accounts.
Mutual fund investment is subject to market risk, please read scheme related documents carefully before investing