What is Inflation, Its Types and How Does It Impact your Investment?

The simplest definition of inflation states that it is the rate at which goods and services prices go up. As of result of rising prices, inflation causes the purchasing power of money decrease over time. While the term inflation can be used broadly to indicate an overall rise in prices with time, it can also be applied to a specific basket of products like food grains, vegetable, petrol and diesel, medicines, real estate, etc. The rate at which inflation has risen over a specific period of time usually on a monthly, quarterly or annually basis is termed respectively as the monthly inflation rate, quarterly inflation rate, and annual inflation rate respectively.

As an investor, there are 4 key types of investments to consider – fixed income investments, market-linked investments, commodities and real estate. Inflation impacts each of these types of investments differently:

1.Fixed Income Investments: Because the returns of fixed-income investments like bonds, fixed deposits and recurring deposits are fixed until maturity, the potential returns from these investments decreases with an increase in inflation. So returns of fixed return investments is negatively correlated to inflation. Inflation also has a similar negative impact on returns provided by debt-oriented instruments like debt mutual funds.

2. Market Linked Investments: The most common examples of market-linked investments are equities like stocks and equity mutual funds. These investments have the best potential to beat inflation in the long-term as they feature a positive correlation to rising inflation. This is because, typically rise in inflation leads to a corresponding increase in the returns from these investments.

3.Commodities: Commodities like gold and silver typically have a favorable correlation with inflation. Historically, gold investments in India have been used to hedge against rising inflation in the long-term. However, the ability of these investments to beat inflation is typically less than that of equities especially in growing economies.

4.Real Estate: Real estate investments typically appreciate with time so higher inflation usually has a positive impact on these investments. However, growth in the value of real estate and real-estate derivatives like Real Estate Investment Trusts (REITs) also depends on government policies and demand that may be adversely impacted by rising prices. So real estate prices and inflation feature a positive correlation only to a certain extent.

So investors need to carefully consider their allocation towards different asset classes to generate portfolio returns that beat inflation while minimizing overall volatility of investments.

There are different kinds of inflation, each of which is defined by its leading cause or rate of growth:

• Cost-push: The cost of manufacturing products & services rises leading to a rise in prices. Common examples include an increase in the cost of labour and raw materials leading to inflation.
• Demand-pull: When the demand for products and services exceeds what can be produced at the time, prices increase.
• Deflation: A negative inflation rate, leading to a decrease in prices of goods and services, is the opposite of inflation.
• Disinflation: A pause in the increase of prices for goods and services or a decline in inflatio
• Reflation: Government deliberately stimulates the economy by boosting the money supply or government spending. Additionally, when a government lowers interest rates, inflation may result.
• Creeping: Low or mild inflation, with annual price increases of less than 3%.
• Walking (trotting): While prices gradually increase, the annual inflation rate remains low.
• Running (galloping): At an inflation rate of over 10% per year, prices rise significantly into the double digits.
• Hyperinflation: Over 1,000% annual inflation is extraordinary and spinning out of control.
• Stagflation: A high rate of inflation that occurs during a period of economic recession.

Based on the Wholesale Price Index (WPI), the annual inflation rate for all of India in May 2023 is estimated to be 4.25%. In April 2023, the annual rate of inflation was 4.75%. This reduction in inflation is at least in part due to cuts in excise duty on crude oil and diesel, as well as reduction of import duty on edible oils and various raw materials. In addition to this, recent RBI policies have also played a part in reducing liquidity in markets, which has led to reduced inflation even though other factors like GST rates have remained unchanged.

Depending on the sort of investment, inflation may have a different effect. For example, inflation can hurt the performance of assets that provide payouts at a predetermined interest rate on yearly like, like traditional bonds, treasury bills, or bank certificate of deposits (CDs).

Inflation may or may not adverse impact returns from equities. While the economy is strong and inflation is on the rise, bubsinesses might be selling more, which would boost the value of their stock. Although this lowers their value, businesses will also have to pay more for labour and raw supplies. The corporation's success in holding a stock can determine whether inflation will assist or hinder it.

On the other hand, when inflation has been high historically, precious commodities like gold have fared well, so including gold investments in your portfolio can help hedge you against inflation risk. Finally, certain assets have their inflation risk indexed. Their income is steadier because it increases with rising inflation and decreases with falling inflation. This function is available in some floating rate bonds and annuities for an additional fee.

One of the best strategies for consumers to beat inflation is investing in assets that offer higher returns than the inflation rate. For example, experts often advise investing in diversified index funds based on broad market indices as well as other types of equity investments for long-term wealth creation. Choosing a mix of these and other suitable investment options in India lowers your risk of losing money because of inflation and allows you to engage in asset allocation in order to diversify your portfolio.

The earlier you invest and the longer you stay invested, regardless of where the market may be when you start, the better. This is because compounding returns—when you reinvest your gains to earn even more—allow you to make more money over time. So even though no one can accurately predict how the market will move in future, one of the best methods to fight inflation is to invest wisely in particular assets for the long term.

It doesn’t matter what goes well or bad in the world; inflation will always be concerning. A person's money will be safe and grow due to wise decisions. Otherwise, we know that inflation would do what it is meant to do—drain bank accounts. A better understanding of inflation is a must for this generation.