Inflation is everywhere! Everyone is talking about inflation as it touches a 13-year high.

But what exactly does inflation mean? What are the causes of inflation? How does it affect the common man and the economy as a whole?

Inflation is basically a rate of increase in the price of goods and services which in economics defined as “The overall general upward price movement of goods and services in an economy, usually as measured by the Consumer Price Index (CPI).” In India, however, it is measured using the wholesale price index (WPI). The CPI is based on a basket of goods and services with different weights, reflecting the expenditure of a typical consumer. The weighted average of price rises of these goods and services gives the inflation figure. Inflation simply reduces the worth of your money. For example: the same 1 kg of apples you used to buy at Rs. 100 will cost you Rs. 110 next year, if the inflation remains at 10%.

There are two theories in the economics that are generally accepted as the causes of inflation.

• Demand pull inflation – Happens when too much money chases too few goods. This situation mostly exists in a growing economy where there are huge expansions from the government and private sector leading to increase in employment which in turn will increase the purchasing power of the consumer. This will lead to an environment where people have got too much money to buy goods and/or services but the supply of goods and services are not growing at the same rate resulting in a supply and demand mismatch. To adjust this, producers will increase the price of goods.

• Cost push inflation – Happens when the aggregate cost of resources goes up for the companies due to decrease in supply or increase in taxes. Companies pass this increase on to consumers in the form of increased prices. For example, crude oil prices have gone up sharply in past few months on account of decrease in supply. The economy sectors where oil is the part of their cost element will pass on this increase to customers by increasing prices of their goods and services.

It is not necessary that only one type of inflation exists in an economy at a time. They can co-exist. For instance, in India right now we have both types of inflation, oil and metal prices have gone up to record highs, giving rise to cost push inflation. At the same time, purchasing power has also increased due to increases in employment, wages, and easy availability of money, creating demand pull inflation. This combined effect has taking inflation to the 13-year high that we are experiencing right now.

Inflation is not always an evil; within limits, inflation is required for an economy to grow. It’s said that inflation is the sign of a growing economy. Imagine an environment where there is no price increase; in fact prices are falling (this situation is opposite of inflation known as deflation). There will be no increase in wages. Nobody would like to have that environment.

But when inflation is too high it adversely affect the consumer and the economic conditions of the nation as well:

• In a fixed interest rate environment the creditor will lose money if he has not properly estimated the inflation and accordingly fixes the interest rate. High inflation can sometime result in negative real interest rates. This can be currently seen in India as the inflation is touching 11.4% and the interest rate on fixed deposit is 9% it is actually giving negative return of 2.4%
• It decreases the savings of the individuals. As the prices increase, the consumer has to shell out more money from his pocket to buy the same products but his income has not increased. Therefore he has to eat up his savings.
• As savings get reduced, automatically investments will reduce, affecting the economy negatively.
• If the inflation in one country is greater than another, the products and services of the former will become less competitive due to the increase in its prices.

To control inflation central banks take monetary actions and government takes fiscal measures. But individuals should also take some steps to get over it. They should invest their money in the investment avenues which gives better return, should try to minimize unwanted expenses, reduce the consumption of the commodity that has become very expensive, and find out some substitute that will help them in managing their own inflation.

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.