Inflation and its Key Driving Factors
Inflation is simply the general upward movement in prices of goods and services. Simply put, inflation is the rate at which prices rise and results from excess demand or short supply. In a particular period, increasing prices mean that a unit of currency can buy less than it did in previous periods. In general, high inflation is considered bad for the economy since it leads to a fall in purchasing power, which negatively impacts cost of living and ultimately curtails a country’s economic growth.
Many factors can push inflation rates upwards. One is the increase in the economy’s money supply. India’s monetary authority, the Reserve Bank of India (RBI) can increase India’s money supply by printing more of it or by purchasing government bonds from banks on the secondary market. As more rupees enter India’s economic system, the currency’s value erodes and thus increases inflation.
Currency devaluation can also push inflation up. The lower value of the rupee erodes purchasing power because products cost more. Inflation also increases due to the forces of demand-pull and cost-push. Demand-pull inflation is when the demand for (certain) goods or services is greater than the economy’s ability to meet these demands. Since demand outpaces supply, it puts upward pressure on prices, thus increasing inflation.
How Inflation Is Calculated in India
Governments measure inflation by comparing the current prices of goods and services to their previous prices. Calculating the inflation rate enables governments to understand the overall impact of price changes on the economy over a specific time period (e.g., a year).
Different sets of goods and services are selected to create a “basket” and track their prices. A price index is then calculated for the basket to indicate inflation. The Consumer Price Index (CPI) and the Wholesale Price Index (WPI) are the most commonly used price indexes.
WPI measures the prices of 697 goods at the wholesale level and shows the combined prices. Comparing the WPI over different periods shows India’s inflation situation. Post 2014, the RBI shifted from the WPI to the CPI to measure inflation. The CPI measures the price change of 260 goods and services at the retail level.
Why Rising Inflation Results in Falling Bond Prices
When prices go up over time (inflation), the purchasing power of each interest payment that a bond makes is eroded. So, if a ten-year bond that pays Rs. 2000 per year will buy less than 10 years from now due to inflation. Such erosion in purchasing power affects investor sentiment because they will worry that the bond’s yield won’t be able to keep up with inflation. As a result, investor demand for that bond will fall, leading to a price drop.
Bond yields rise because bond issuers must pay a competitive interest rate to get investors to invest in their bonds and protect as much purchasing power as they can.
Furthermore, as inflation rises, central banks will increase short-term interest rates to bring the demand-supply situation under control (by increasing interest rates, the central bank will take liquidity out of the system so that too much money is no longer chasing too few goods). But with rising rates, the prices of existing bonds will fall. The longer the bond’s tenor, the more the fall in price. So long bonds will yield negative returns in inflationary scenarios.
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Frequently Asked Questions
What are the key takeaways from this article?
Inflation is simply the general upward movement in prices of goods and services. Simply put, inflation is the rate at which prices rise and results from excess demand or short supply. In a particular period, increasing prices mean that a unit of currency can buy less than it did in previous periods. In general, high inflation is considered bad for the economy since it leads to a fall in purchasing power, which negatively impacts cost of living and ultimately curtails a country’s economic growth.
Who should read this article?
This article is designed for retail investors, first-time bond buyers, and anyone looking to understand fixed income investments in India.
How does this relate to my investment portfolio?
Understanding these concepts helps you make informed decisions about asset allocation and build a diversified investment portfolio.
