How Inflation affect Your Savings?

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One must have surely heard the famous quote "Inflation Is A Painless Disease with a Cure That Hurts ". One has surely gone to the theatre in the last few weeks. The tickets are priced in the range of INR 200-INR 300.What was the price of a movie ticket about 5 years ago? Let us consider the price of vegetables and fruits especially apples in the local market of your city. The vendors quote a ridiculously high price of INR 150 Rupees per Kilo. One must have surely heard from one's parents and grandparents the cost of fruits, vegetables, fish and other products in their youthful days. It must have been a few rupees in your parent's time and a few paisa's in your grandfather's time. So What Led To The Ridiculously High Current Prices Of All These Items? Your Dad's salary must have been a few Hundred Rupees about 35 Years ago and now is close to a Lakh of Rupees. Yet Money Never Seems To Be Enough. I spent a few hundred Rupees as fees during my schooling days. Nowadays schooling in a city like Bangalore costs INR 50000 for a student who is in the first standard. Mind Numbing Isn't It? Do Your Salaries Match Such High Standards Set By Inflation? Is it time to ask your Boss for that long pending raise?

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What Is The Effect Of Inflation On My Savings?

One notices a general rise in prices of all commodities with the passing of time. This is known as Inflation .Let us consider that one invests INR 10000 in a fixed deposit for a period of one year. The rate offered is 8.5%.After tax rate of return is still lesser that this amount. India's Wholesale Price Index has galloped to 4.86% for the month of June 2013.Retail inflation is 9.87%.for the month of June 2013.This means that your effective or real rate of return is negative. This means that even if you park your funds in the bank in a Fixed Deposit you do not gain any value due to the effect of inflation on your investment. I would not even care to compare the returns on the Savings Bank amounts that lie in your account. This means that you are actually losing money on the amounts you invest in your savings bank accounts and the fixed deposits. The central bank of India known as the RBI used to measure the Wholesale Price Index and not the Consumer Price Index which is a truer measure of inflation. One can note the difference in value between the Consumer Price Index which is closer to 10% while the Wholesale Price Index is around 5%.It is the general belief that CPI should be used as it is a true indicator of inflation.

So How Is Inflation Calculated? What Is The Consumer Price Index or CPI?

Let us take note of the Consumer Price Index which is 9.87% for the month of June 2013.This is a measure updated every month. The components include Food, Clothing, Fuel, Housing, Education, Medical, Recreation, Transport, Personal Care, Household Items among others. If one has a look at these components one can easily conclude that these are the items one uses or depends upon in his day to day life. If one looks at this index and compares this to real life situations what do you notice? As affluence increases in society people shift their eating patterns from cereals to protein rich foods. There is a general shift mainly noticed in the Southern Regions of India where people shift from eating plain rice to allocating a greater share to pulses such as Soybean, lentils, beans, fish, eggs and meat in their diet which are rich in proteins .Protein rich foods are also heavily consumed in the Northern parts of India. This has led to the doubling in prices of Onions in June this year as compared to the previous year. Prices of Wheat and Rice have increased at the rate of 19% and 13% from the previous months. The protein rich foods are soaring with the prices of chicken and fish hitting ridiculously high levels. Let us take another major component of the CPI which is fuel. The prices of Petrol, Diesel and LPG are rising at a phenomenally high level. Petrol prices rose by INR 1.55 per Litre on July 17th 2013 following a series of price rises to INR 70.44.There has also been a steady rise in the prices of Diesel in the past few years. The prices of subsidised cylinders in New Delhi were INR 410.50 per cylinder in the month of April where one can avail a maximum of nine subsidised cylinders. The market rates of unsubsidised LPG cylinders in New Delhi are INR 901.50 in the month of April 2013.This has led to a huge rise in the CPI supported by a rise in food and fuel prices. Another factor one needs to concentrate on is the housing sector. Prices in Chennai mainly in the housing sector have gone up around 25%.In Mumbai they have gone up by around 30%.Prices in Delhi have increased around 40%.This has contributed to a rise in the value of the Consumer Price Index. The rise in fuel, food and housing has resulted in a general price rise in transport, recreation, education and so on which contributes to the rise in the CPI .The post office workers are sent to collect the primary data mainly in the rural areas. They collect data by using questionnaires from a test sample. They then use Statistical techniques such as simple random sampling, cluster sampling, systematic sampling and homogenous sampling to arrive at the requisite result. Similarly National Sample Survey Organisation collects data from the urban areas. The old CPI had a base year of 1984-1985 for Urban Non Manual Employees and 1986-1987 for agricultural labourer's .The new CPI has a base year of 2010-2011 which will soon be shifted to 2011-2012.

So How Is The Consumer Price Index (CPI) Calculated?

One knows that the Consumer Price Index has a base Year of 2010-2011.This consists of a number of components as explained above. One notices a price increase in all the components of the index over a period of time. Let us consider a base value of 100 in the year 2010-2011.In the year of 2012-2013 owing to a general increase in all prices and components of the index the value changes to 125.However the knowledge of this movement in values alone does not help us. One has to convert it to a percentage. However if there is too wide a gap between the base year and the current year it would not be a proper representation of the true value. Hence for the year 2013 one would have to replace the base year 2010-2011 by 2011-2012.

[(B)-(A)]/A * 100 Here one has the value of 100 for the base year and A=100 (2010-2011).B=125 (2012-2013).

(125-100) / 100 * 100 =25%.This represents a 25% change in the value of the components of the CPI index over a couple of years.

 

What Is The Wholesale Price Index or WPI?

One notices in the WPI the components include food products and fuel just as in the consumer price index. In addition one notices leather goods, transport equipment, Industrial Machinery, Sugar, Edible Oils, Rubber, Paper Products, Plastics, Chemicals, Iron and Steel, Cement, Wood and so on.WPI is most widely used in India and includes a measure of components used in Industries .Even though this index is widely used CPI gives a true measure of the rise in retail prices in Society. The WPI is updated every week. It uses 435 commodities while calculating the inflation. The latest WPI is a measure of prices of components about two weeks back. Housing is not reflected in this index and this cannot be a true measure of inflation in society.

How Is WPI Calculated?

One has the formula (WPI at the end of the year-WPI at the beginning of the year)/ (WPI at the beginning of the year) * 100.Let us assume the WPI value on January 1st 2010 is 130.The value on January 1st 2011 was 142. One has 142-130/130 * 100 = 9.2%.Thus one can say the inflation for the Year 2011 was 9.2%.

Inflation Indexed Bonds - A Solution To This Problem?

RBI has just released the WPI data for the month of June 2013.This value is 4.86%.But does this value represent the true prices of the month of May 2013. No definitely not?. This may be a reflection of the prices of September 2012 .This data is then interpolated to arrive at an accurate figure for the month of June 2013.A lag is allowed as adjustments due to revision might be necessary as you must have seen on a regular basis in recent years. Let us see how inflation indexed bonds work. We have Mr Rakesh who purchases a 5 year bond of face value INR 100.The coupon rate is 7% per annum. According to this Mr Rakesh should earn INR 107 inclusive of interest every year. Do you think is it fair if the inflation rate has changed or increased to 8% when the coupon rate is just 7%.One now has Inflation Indexed Bonds in order to resolve this shortfall in returns. However if inflation rate falls then you suffer losses on your investment. Now you will be able to understand more clearly about how inflation indexed bonds work with the help of the following calculations.

One notices different values of inflation over a 5 year period. As shown in the table the principle as well as interest amount changes according to the inflation rates.

 

Year 1: Let us consider that inflation rate is 7% as shown in the table . Initially WPI index was 200 which changed to 214.

Principal = issue time principal * (current WPI / WPI index at issue time).
New Principal = 100*(214/200) = 107.
Interest based on the coupon rate =7% of the new principal =7% of 107=INR 7.49

 

Year 2: Let us consider that inflation rate is 6% for the following year. So the WPI is 214*106%= 226.84 (6% shown in the table).
New Principal = 100*(226.84/200) = 113.42.
Interest = 7% of the new principal =7% of 113.42=INR 7.9394

 

In this way one can see the principal and interest goes on increasing and changing as per the inflation rates. If inflation rises as you must have noticed then you will get a higher principal and a higher interest and vice versa.

I would like to end this article with the famous quote " When You Reach The End Of Your Rope Tie A Rope And Hang On ".Never allow inflation to affect your finances and utilise all possible financial instruments to beat inflation.

 

For further information on the topic you can CONTACT Prajna Capital on 94 8300 8300 by leaving a missed call.

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