How Inflation impact on exchange rate and returns

If we go to see 3 or 4 topics around which Finance or Economy revolves, inflation is one of them. It is such a topic which has an impact on each and everyone starting from a person in a village to Multinational Companies. Inflation affects normal public due to increased cost of living and remuneration and affects Multinationals in form of its impact on huge Projects they undertake because it changes the Cash Flows from that project. In short, this impacts all of us so it is very important for us to know about inflation and how does it affect the whole economy. Higher the Inflation, lower the purchasing power of the currency. (e.g. due to inflation you will not be able purchase same quantity of goods “X” after 1 year in Rs. 100 that you are able to purchase today). Inflation is different for different commodities, services, Medical care, housing, etc.

Causes and types of Inflation:

There are varied reasons for inflation some of them being increased demand not backed by proportional increase in supply (Demand Pull inflation), increase in costs of products (Cost pull inflation), increase in taxes, droughts, black marketing, hoarding of goods, etc. Also, Inflation causes inflation as one product which has inflated is input for some other industry and in turn that product’s price will also increase due to increased cost of input.

How to measure inflation:

As inflation is different for different sectors, products, services, etc, it is very difficult to get an idea about how much inflation is by looking at individual figures of inflation. So, such a method which gives an overall idea about inflation countrywide is necessary. In India 2 most popular methods used are CPI (consumer price index) and WPI (Wholesale Price Index) are used. Basically, Consumer Price Index measures price increase at the Retail level (Consumer level). It includes Food items, medicines, education, Services, etc in its basket or index which would be used to measure inflation. Wholesale Index consists of Industrial goods, Fuel, etc in short goods which are at Producer level. It excludes services out of its scope (58% of our GDP). This means that CPI is more appropriate than WPI. So since last year or 2 we have started using CPI as an indicator of Inflation in India.

Current trends of Inflation:
CPI : Since last 6 months CPI is around 5% and WPI is around 2 odd% (Annualized.)

WPI is low because of high Weightage of fuel and commodities which are on a deflatory trends globally. Infact it was –ve for 7 months altogether till March 2016.

Impacts of Inflation:

Is inflation Good or is it an Evil ?? It Depends !!

Almost everyone thinks inflation is an evil, but it isn’t necessarily so. Inflation impacts different people in different ways. We like to complain about prices going up, but we often ignore the fact that income would be rising as well. The question shouldn’t be whether inflation is rising, but whether it’s rising at a quicker pace than your income. It also depends on whether inflation is anticipated or unanticipated and at what rate. It impacts your return on investment by reducing the return to the extent of inflation. Return on investment after adjusting the inflation is called real rate of return on investment. Inflation also impacts foreign exchange rates of the currency.

Impact on Foreign Exchange rate:

Amongst the countries which have a higher rate of inflation than others, that country’s currency tends to depreciate against other country’s currency where inflation rate is lower. Take an example of Rs. vs. $. Rs. keeps on depreciating against $ as inflation in India is around 6 % to 7 % ­and in U.S., it is around 1%. So is the case with Rs. vs. £.

Impact on Return on investment

The figures of rates of interest, return on investment are generally nominal rates i.e. before adjusting for inflation. Your real rate of interest or real rates of returns will reduce on adjusting inflation. This can be easily understood by an example illustrated:

Take a case where you invest in a Fixed Deposit in a bank

Initial Investment in Fixed Deposit: Rs.1000

Rate of Interest: 10% p.a. (We can say nominal rate of interest)
Inflation Rate: 7% (always represented p.a.)

What is Nominal rate of interest and real rate of interest in the above case?

Nominal rate of interest in above case is 10%. Generally all rates of interest which are declared, are nominal rates except as otherwise prescribed.

Real rate of interest in above case is: Real rate = (1+ nominal rate) / (1+inflation rate) = [(1+10%)/(1+7%) – 1] = 2.803%. ­­­­­

Also, do you know by and large your rate of interest return (nominal rate) on investment would be almost same whether you invest in India or in US or anywhere in the world? This is because of inflation, interest rate and exchange rates.

Say you have Rs.10,000 in India or $200 in U.S. and 1$ =Rs.50
Rate of interest in India = 8% Inflation rate in India = 6%.
Rate of Interest in America =1.5% (approx) inflation =0.50%
1 year later 1$ = Rs.52.73
If you invest in India amount after 1 year = Rs.10,800.
If you invest in U.S. amount after 1 year = $203 and amount in Rs. = $203*52.73 =Rs. 10,705.

The above foreign exchange rate is not exactly true as foreign exchange rates are very volatile and it is difficult to estimate them.

From above we can see that return on investment will be almost similar in U.S. or India as they also depend on Exchange rates of currency that in turn are dependent on rates of inflation. Foreign investors try to maximize their returns on expectations and hedging of foreign currency rates and risks associated therewith as it can have a positive impact or also adverse impact on return on investment.

Protection From Inflation

Inflation is here to stay, Right?? Can we get protection from it?? How? Yes of Course, there are securities called CIPS (Corporate (non-govt.) Inflation Protected Securities) or TIPS (Treasury (govt.) Inflation Protected Securities) i.e. Inflation protected. They give you 2 types of return 1st is basic return and 2nd is return which is linked to inflation and varies in proportion to inflation rate or index of inflation which protects you from inflation.

Conclusion:

Finally, inflation is a sign that an economy is growing. No one likes stagnant salary, right ?? In some situations, little inflation (or even deflation) can be just as bad as high inflation. Generally, a rate of 4-6% is preferred rate of inflation and this may vary country to country also.

The lack of inflation or deflation may be an indication that the economy is weakening or stagnating. As now we can understand, it’s not so easy to label inflation as either good or bad – it depends on the overall economy as well as your personal situation and its rate. Hope you all have enjoyed !!

Disclaimer:

This document is for general guidance and informational purposes only, and does not constitute professional advice. You should not act upon the information contained in this communication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this communication, and, to the extent permitted by law, author accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this article or for any decision based on it. The above is based on data and information in 2016.