Our real friend in the Government is the RBI Governor. He is the ONLY man who is concerned about Inflation. It is inflation that hurts YOUR capital, savings and investments. This is the figure that makes it necessary to build a huge corpus for our retirement. Use any calculator and see the amount of money that you need to save/ invest for your old age. Even a 1% change in assumption has a huge impact on your Retirement fund requirement.

What is Inflation risk?

I have referred to investment risk very many times in the past. This is a really scary risk in the Indian context NOW, as the inflation rates are sky rocketing.

What exactly is Inflation risk?

Inflation risk is the danger that an increase in price levels (normally for a sustained period of time) will undermine the purchasing power of a bond’s fixed interest payments. In case of a portfolio we normally try to earn more than the inflation rate.

The Real Return of a portfolio = Nominal return MINUS inflation.

Investors often are attracted to bond (this includes income funds, income opportunity funds, floating rate funds, gilt funds, etc. – normally talking of debt funds with maturity exceeding ONE year) mutual funds because of their regular payouts from interest earnings. These payouts, ARE, subject to inflation risk. Inflation erodes the purchasing power of any investment. It is particularly scary for investments that pay out a fixed stream of interest over a period of time, such as bonds, national savings certificates, post office schemes, and of course the Indian favorite, BANK deposits. As inflation increases the prices of goods and services, investors find that their interest earnings are not keeping pace.

For example, suppose Rs. 10,000 in a bond (remember we are talking of a single bond like State Bank of India bond) earns 9% interest, but inflation is 8 percent per year. Although this bond will earn Rs. 900 in interest every year, inflation will make goods and services more expensive. Initially, the Rs.500 in interest will buy a certain amount of goods and services (a basket). After a year, that same basket will cost Rs. 972 because of inflation, but the investor will still only receive Rs. 900 in interest income. Year after year as prices rise, the same Rs. 900 in interest earnings will buy lesser and lesser goods and services in the market. This is what is meant by inflation eroding the purchasing power of an investment. The longer a bond’s maturity, the greater its inflation risk. Bond yields often incorporate expectations of inflation so that investors are compensated for expected inflation risk. If inflation rises by more than was expected when the bond was issued, investors will find that the interest and principal returned to them will be worth less than they had anticipated.

So when the market expects higher inflation in the future, the market expects the bond issuer to pay a high rate of interest, for longer duration bonds. So if SBI were to come out with an issue today people WILL EXPECT SBI to pay about 9.3 % interest – simply because the CPI figures are pretty close to this number.

CPI: Consumer Price Index.

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  1. a related inflation risk is the lifestyle inflation… simply put, our aspirational levels fast surpass the inflation expectations. when upgrading from maruti 800 after 10+yrs, would the buyer still buy the same car at increased price or end up with a honda city (hopefully because he/she is earning far more)? many items (mainly electronics) have gone down in price, but since you don’t buy nokia 1100 again at a price lower than 5 yrs back, but a nokia lumia 520, the published inflation rates may not be enough…

  2. But, Last 10 years, our Inflation is never under 5%. Whether 10% is not such a long period? When will be inflation of less than 1% ( like USA, eurpoe) will happen in India.
    Our increments are in between 4-6%, but price increase is more than 10-15%. Govt just showing off as 8-10%.
    All white goods are increasing 10% YoY.
    All basic stuff increasing 8% YoY.

  3. Sreekanth Yelicherla

    Karthik, The GDP of India is between 4-6% whereas that of the US is 1-2%. Does it mean India is better than the US? The comparison of inflation between India and the US is also same. An emerging economy will have a higher inflation (as growth increases) compared to a developed economy, so the comparison is not at all apt. The strength of an economy is shown by its stock markets and currency. As the Indian rupee is week compared to the US dollar, the inflation is also not comparable.

  4. Sreekanth Yelicherla

    Karthik, The GDP of India is between 4-6% whereas that of the US is 1-2%. Does it mean India is better than the US? The comparison of inflation between India and the US is also same. An emerging economy will have a higher inflation (as growth increases) compared to a developed economy, so the comparison is not at all apt. The strength of an economy is shown by its stock markets and currency. As the Indian rupee is weak compared to the US dollar, the inflation is also not comparable.

  5. there is no correlation/causation between growth and inflation in emerging or any economy for that matter,as a matter of basic economics.

    inflation is caused by increase in money supply .if services and goods keep up with the pace of money expansion, prices dont rise.otherwise they rise. originally inflation was defined as an increase in money supply and not merely prices.

    the free market is a great deflation creator ie lower prices.more production in areas where govt is least involved(tech ) usually sees lower prices consistently.

    the US was an emerging economy in 1880-1913 and it still had the best years of real growth.this period was accompanied by consistent deflation. ie poor people who could not invest,could simply hold their money in their mattresses and see its purchasing power go up.
    after the end of gold standard, we dont have this wonderful blessing for the poor people anymore
    today people associate growth and inflation

  6. There is massive deflation in productive sectors like IT and Tech. An iPhone would cost $1 Billion in 1970 and it would be the size of a room. Ofcourse, people used the computing power then to calculate scientific computing problems. Now, we use the computing power to watch bollywood movies. Anyway, point was growth in IT did not necessarily cause inflation. Productivity increase should ideally make things cheaper and cause deflation. Even commodities are relatively cheaper over a longer time frame (a century or more).

  7. what I the logic of taxation on bonds and fd’s which yield less than the govt estimated inflation….?
    Long term capital gains on debt bonds and fd’s are the most stupid and day time looting of the poor.

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