Inflation

Inflation

DEFINITION : Let us understand what is Inflation. Classic definition of Inflation is "The rate of increase in prices over a given period of time". Inflation is a measure of the rate of rising prices of goods and services in an economy. In other words it is the decline of purchasing power of a given currency over time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time.

MEASURE : As a currency loses value, prices rise and it buys fewer goods and services. This loss of purchasing power impacts the general cost of living for the common public. Inflation is generally measured by comparing the price of a basket of goods over the base period. The consensus view among economists is that sustained inflation occurs when a nation's money supply growth outpaces economic growth (Well this we will leave for a discussion in a separate thread).

CAUSES : The above effect of losing value can actually reach the people through three ways. 

1. Cost push : This is a rise of cost of production viz. raw material, commodity prices etc. A sharp increase in production costs could happen for many reasons eg in the current pandemic, Supply chain disruptions, increase in commodity prices due to production disruptions and semi conductor shortages are some reasons for the production costs to go up. These costs passed on to consumers, increase prices for them.
2. Demand pull : Money supply in an economy spurs demand and when the demand increases more than the production capacity in an economy, prices rise. A demand supply gap created, results in increased prices.
3. Printing more money : This can play out through different mechanisms in the economy. This supply of money can be increased by either printing and giving more money to people, or by selling bonds through banks. Any route adopted, excess supply of money, devalues it and the money loses its purchasing power.

INDICES FOR INFLATION : 

1. CPI : Most common index used for measuring Inflation is Consumer Price Index (CPI). In any economy, generally a basket of goods is defined and prices for buying one unit of this basket is compared over the base period, this measured as a percentage indicates CPI. In 2013, the consumer price index replaced the wholesale price index (WPI) as a main measure of inflation. In India, the most important category in the consumer price index is Food and beverages (45.86 percent of total weight), of which Cereals and products (9.67 percent), Milk and products (6.61 percent), Vegetables (6.04 percent), Prepared meals, snacks, sweets, etc. (5.55 percent), Meat and fish (3.61 percent), and Oils and fats (3.56 percent). Miscellaneous accounts for 28.32 percent, of which Transport and communication (8.59 percent), health (5.89 percent), and education (4.46 percent). Housing accounts for 10.07 percent; Fuel and light for 6.84 percent; Clothing and footwear for 6.53 percent; and Pan, tobacco and intoxicants for 2.38 percent. 
2. WPI : The WPI is another popular measure of inflation, which measures and tracks the changes in the price of goods in the stages before the retail level. While WPI items vary from one country to other, they mostly include items at the producer or wholesale level.
3. PPI : The producer price index is a family of indexes that measures the average change in selling prices received by domestic producers of intermediate goods and services over time. The PPI measures price changes from the perspective of the seller and differs from the CPI which measures price changes from the perspective of the buyer.

INFLATION GOOD OR BAD : Inflation can be construed as either a good or a bad thing, depending upon which side one takes, and how rapidly the change occurs.

For example, individuals with tangible assets that are priced in currency, like property or stocked commodities, may like to see some inflation as that raises the price of their assets, which they can sell at a higher rate. However, the buyers of such assets may not be happy with inflation, as they will be required to shell out more money. Inflation-indexed bonds are another popular option for investors to profit from inflation.

On the other hand, people holding assets denominated in currency, such as cash or bonds, may also not like inflation, as it erodes the real value of their holdings. Investors looking to protect their portfolios from inflation should consider inflation-hedged asset classes, such as gold, commodities and real estate. 

Generally speaking a stable rate of Inflation is desired and this job is attributed to the central bank. The central bank, In India - RBI has this a the primary objective for their monetary policy. They regulate the availability of money in the hands of the people (sometimes called liquidity).

EFFECT ON EQUITY : Stocks are considered to be the best hedge against inflation, as the rise in stock prices is inclusive of the effects of inflation. Since additions to the money supply in virtually all modern economies occur as bank credit injections through the financial system, much of the immediate effect on prices happens in financial assets that are priced in currency, such as stocks. Inflation and the Indian Stock Markets

The price of a share in the stock markets is determined by its demand and supply that is affected by a range of factors like social, political, economic, cultural, etc. Anything that affects the investor can have an impact on the demand and supply of stocks and inflation is no different. Here is a quick look at the impact of inflation on stock markets:

1. The purchasing power of investors

Since inflation, by definition, is an increase in the price of goods and services, it also is an indicator of the decreasing value of money. So, if the inflation rate is 5%, then Rs.10,000 today will be worth Rs.9,500 after one year. If the inflation rate increases to 10%, then the same amount would be worth less in the future. Hence, the purchasing power of investors decreases as the inflation rate increases.

This can have a direct impact on the stock market since investors would be able to purchase fewer stocks for the same amount. 

2. Interest Rates

When inflation rates increase, the Reserve Bank of India (RBI) increases the interest rates for deposits and loans. The idea is to incentivize people to save money and curb excessive liquidity bringing the inflation rate down. Since loans get costlier too, the cost of capital for companies increases. Hence, the projected cash flows are valued lower, resulting in lower equity valuations.

3. Impact on Stocks

As the inflation rate rises, speculation about the future prices of goods and services leads to a market environment that is highly volatile. Since prices are rising, many investors will speculate that companies will experience a drop in profitability. Hence, some investors might decide to sell the shares leading to a drop in its market price. At the same time, investors optimistic about the company making profits in the future might buy these stocks causing a volatile environment.

Value stocks are strongly impacted by a change in the rate of inflation. The market price of value stocks is usually directly proportional to the rate of inflation. Therefore, when the inflation rate rises, value stocks tend to perform better. On the other hand, Growth stocks have minimal cash flows. Therefore, they have a negative correlation with the rate of inflation. The market price of these stocks drops when inflation rates rise.

Lastly, if you look at dividend-paying stocks, then an increase in the rate of inflation can cause a drop in their market price. This is because, with rising inflation rates, dividends can fail to beat inflation making such stock less attractive to investors. 

4. Long-term benefits of rising inflation rates on stock markets

Inflation is not the devil that it is assumed to be. In fact, a controlled rise in inflation rates is a sign of a growing economy. If you turn the pages of history, you will find that on most occasions, a rising inflation rate is synonymous with an improvement in the Gross Domestic Product (GDP). It is important to remember that if the inflation rates are too high, then the purchasing power can erode drastically creating havoc in the economy. However, if the inflation rates are too low, then the growth of the economy can get stunted. 

Therefore, investors must compare inflation rates in recent years to assess if the increase is sudden or sustained. If the inflation rates are rising steadily, then it can be healthy for businesses and the economy and be a good environment for stocks.

UNEXPECTED INFLATION IS A PROBLEM : The stock market, of course, anticipates that there is a certain amount of inflation each year and adjusts what the expected returns should be against the expected inflation. 

If, for example, investors expect a return of roughly 6% a year after inflation (including dividends), and inflation is 2% a year, investors will come to expect a roughly 8% return a year when inflation is factored in (this is in fact about the long-term return on stocks, over many decades).

But if inflation suddenly goes from 2% to, say, 4% very quickly, history indicates the overall market will react negatively.

That’s because investors will now demand a higher return to compensate for the now-higher risk. Instead of an 8% return, investors may demand a 10% return. Prices will likely drop.

This change in expectations is evident in the historic record. A 2000 study conducted by Steven A. Sharpe at the Federal Reserve concluded that “market expectations of real earnings growth, particularly longer-term growth, are negatively related to expected inflation ... inflation also increases the required long-run return on stocks.”

The effect of inflation can vary from sector to sector. For example, growth stocks tend to underperform when inflation is higher. That’s because growth stocks have much of their earnings expectations in the future, and when rates rise, it hurts those expectations. With the value stock, each year the company makes about the same amount of profit. With the growth stock, the profit is much farther out in the future. Investors who buy growth stocks estimate what the current value of that future stream of earnings will be.  When inflation or interest rates start going up more than expected, it reduces the current value of the future stream of earnings. Part of the reason is because the returns on the risk-free rate of return — government bonds — goes higher, making bonds more appealing against stocks.A Another reason is that higher inflation and interest rates will impact the future profitability of the companies.