Taking Interest in Inflation

Courtesy: Farhan Elias article in the newsletter of the Ernakulam Branch of Southern India CA students assocation of ICAI- Sept 2006.

What is interest ?

It is the money that you pay back when you borrow money or receive when you invest money. You invest Rs. 1000 in a bank at 6% interest. A year later you get Rs.1060. This Rs. 60(1060-1000)is your interest received. Right? No, WRONG! This is just your nominal interest. You should always look at the real rate of interest.


The Real Interest Rate = Nominal Interest Rate- Inflation.

Assuming a inflation rate of 5% your return is only 1% (6%- 5%- 1%) Note that the RBI takes a hardening or softening stand( i.e, increases or decreases) on interest rates based on various factors ,the most important of which is inflation.

What is inflation?

It is a general rise in the prices of goods and services in an economy resulting in a fall in the value of money. That is what your parents mean when they say, 'In our times, a loaf of bread used to cost 50 paise, and now it costs Rs.11.50.That is to say 50 paise had value enough three decades ago to buy you a loaf of bread, whereas today it will take twenty- three of such 50 paises to buy you the same thing. Obviously, when inflation goes up, there is a decline in the purchasing power of money.


The two major types of inflation are:

1. Demand- pull inflation: This happens when demand exceeds supply. i.e, a situation of too much money chasing too few goods,causing an increase in prices.

2. Cost- push inflation: This happens when costs rise and producers are forced to increase prices in order to maintain their profit margins. Costs can increases due to rise in output costs, higher wages, or higher taxes.

Inflation is measured with the help of a price index which would typically consist of a number of goods that are important in the particular economy. Most countries across the world use the Consumer Price Index (CPI) to gauge inflation. But here in India, RBI relies on the Wholesale Price Index (WPI).


Interest And Inflation

Central banks look upon inflationary figures as significant factors to initiate changes in interest rates.

A rise in interest rates would cause money to be sucked out of the economy. The reason is that bank deposits grow more attractive, and purchasing power goes down, thereby leading to a dearth of money supply. This in turn causes inflation to come down. It also causes a slow down in economic growth. It’s a time when CASH is King.

A reduction in interest rates would cause money to get flooded into the system. Bank deposits are no longer attractive. Companies start investing more as loans are cheaper. Consumer spending is on the rise. Economy becomes robust as both toplines and bottom lines surge. It’s a time when CASH IS TRASH.

This is a balancing act that central banks have to perform to keep the economy functioning properly.

The Indian Scenario today

‘Inflation hits 5%’. That’s what Reuters reported on the 8th of September. The Finance Minister says that he is confident of containing the inflation at 4.5 to 5%. And also that further efforts will be undertaken by the government to bring the inflation under 4%. Now the inflation rates in India have been marching northwards for quite sometime, from 4.1% in March end to 4.7% at the beginning of July. Our central bank reacted the way any other central bank would have- by raising the interest rates. The benchmark short term rate was raised in last July to 6% up by 25 basis points. This is the third time the interest rates have been hiked this year to curb the inflationary pressures.

But a question arises. Are higher interest rates the answer to increasing inflation? Is it as simple as that? To answer that question, we have to look deeper into the reason behind the inflation. As explained earlier, there are two types of inflation, and the kind we are facing today is clearly ‘cost-push’ inflation. The predominant reason for the inflationary pressures faced by the Indian economy today is the oil price hike followed by the rising prices of primary products mainly vegetables and pulses. Lets consider each of these contributors to the rising inflation. First and formost is the oil price. We are an oil importing nation and therefore price-takers. Any volatility in the politically unstable Middle East can shoot up the prices. Increasing the interest rates is not going to help bring down prices or demand for fuel. Perhaps the government should aim at making India self-sufficient in its energy needs. Promoting the use of alternate fuels, more exploration within the country, or buying oil fields in other parts of the world and, of course, setting up a proper price mechanism for petrol are needs of the hour.

Next the rise in food prices. The reason, supply-side constraints, as pointed out by the Finance Minister. Therefore the rise in prices was on account of supply problems, not because of any demand spurt. Is an interest rate hike the remedy to this? A much better option would be to solve the logistics and storage problems on that front.
As per my viewpoint, last week potato prices were Rs. 12/- and this week it was Rs. 24/- so also the prices of other vegetables, pulses etc. Thuvar dal today cost Rs. 60/- per kg… So also the cost of Rice…True, there was no sufficient stock, to add to that bus/lorry strikes etc. So the above is true, but also as farming/agriculture seems not to be a profitable business, people use the agricultural land for real estate business. There is increase in population and decrese in production. So to some extend there is a demand pull inflation too.

But what can RBI do when the Fed Chairman Mr. Ben Bernanke has been on a rate increase spree? Though he seems to have stopped doing it for some time now. Perhaps they should concentrate on internal issues more than Mr. Bernanke’s Views. However, this is a time when India, on its way to becoming the 3rd largest economy by 2050 (according to Godman Sachs BRIC report), has to look abroad before taking its economic footsteps.

Conclusion

To conclude, the interest rates and the inflation rates have a profound effect on the direction that the economy takes. That also have an effect on our daily lives. Rise or fall in these rates need not necessarily be good or bad. It could very well depend on your personal situation. If your income grows faster than the inflation, you are pretty comfortable. In the long run, investments in the stock market could be a good protection against inflation. If your income is from business, you would prefer low interest rates, but a pensioned individual would like the government to increase interest rates. Understanding interest and inflation are important as they can help you structure your investments in such a way that the changes in their rates would hurt you the least.