Inflation is the rate of increase in prices. Simple.

In times of low inflation people grumble that prices still go up. They will, but at a low rate. Deflation is prices going down!

We have recently seen prices galloping. This has rightly been blamed on crude petroleum oil prices that have been accelerating, seemingly without the hint of a brake.

How is oil the spoke in our own wheel? Why does it cost so much more to fill the kitchen shelves? Oil. Crude oil provides petrol and diesel - fuel for our transport. A hike in its price makes it costlier to produce the fertilizer (an oil product), run the tractor, pump the water (a lot of electricity is also produced from oil products) and bring it to your neighbourhood mandi.

Some inflation is a good thing. Just like a bit of temperature is good for the body (98.6˚F is normal temperature), a bit of inflation makes the economy grow, justifying salary increases and interest on our deposits!

Inflation is dangerous when it is out of control. This can happen when plenty of money is printed. Foreign money entering our economy produces local money; the Government running deficit budgets also creates money supply. When a lot of excess money tries to buy the normal production of goods and services prices go up – INFLATION!! Your salary increases and bonuses also cause inflation, as also the higher interest you get on your deposit. Inflation is a dragon eating up the value of your money, as you need more money to buy the same product.

In the interest of the ecology and driven by higher petro prices, a lot of sugarcane and corn produced is being used to produce ethanol (ethanol is being used as a substitute for oil in cars, trucks), instead of being directly consumed. With agricultural land being limited, there has been a decrease in food production, taking food prices up. We have a new term for this, Agflation.

The Reserve Bank of India (RBI) has been increasing interest rates and reducing the money in the economy to curtail inflation. Will it work, and if it will, how?

Less money available will buy less. Higher interest rates will reduce the feasibility of borrowing to consume – most homes and a lot of vehicles are bought on credit. This will surely impact inflation. But is it enough? What is the cost of the rate hikes?

I believe it was in the year 2000 that our then RBI Governor, Mr. Bimal Jalan, said that the Central Governments of the world do not react to supply side inflation. In the current situation of the RBI’s monetary tightening, would the price of oil drop in response to the Indian rate hikes? Not likely, is my bet.

What then, could this tightening do? For one, this will hurt banks. As money becomes scarce, they need to raise deposit rates. They will also have to maintain a higher Cash Reserve Ratio (CRR, now at 8.75% of their deposits), earning no interest on amounts above 3.5% (and getting only 3.5% interest on that portion). At higher interest more loans will default, ouch! Projects being set up become costlier at higher interest rates. Ongoing housing projects may get delayed as rising interest costs will impact the borrowing of builders. There will be less industrial investment, which will hurt us with lower production in the years to come, meaning a lower GDP, less jobs and a lot more pain. This could just be a return to the old Indian “Hindu rate of growth”, or worse, recession. Oil for the moment, is likely to remain expensive, leading to ‘Stagflation’, which is prices rising in a stagnant economy.

Do you say a prayer, or are we left without a hope or prayer?

Naveen Fernandes is a Certified Financial Planner and Vice-president, Orbis Financial Corporation Ltd, Mumbai. Orbis Financial is a SEBI-approved custodian.