Inflation impact is considered one of the key factors when a Foreign Institutional Investor (FII) makes investment decisions, as it also influences how voters cast their votes for political parties. All these processes are impacted by inflation. When inflation is high, we often see price hikes and increased uncertainty in price fluctuations.
Additionally, policies implemented by the central bank—such as the Reserve Bank of India (RBI) in India—are often designed in a contractionary manner to help curb inflation. However, such policies are usually viewed negatively by the Indian stock market, as they may lead FIIs to slow down their investments or take a more cautious approach.
At the same time, high inflation also affects retail consumers, who may perceive it negatively and associate it with the ruling party, potentially influencing their voting behavior.
How the inflation impact works
Inflation refers to the rate at which the prices of goods and services increase over a specific period. For example, if the price of sugar is Rs. 40 and the inflation rate is 4.5%, the price of sugar will rise due to inflation:
= 40 * 4.5% = 1.8
= 40 + 1.8 = 41.8
Thus, the inflation-adjusted price of sugar would be Rs. 41.8.
It is crucial for salaries or purchasing power to outpace inflation impact. If inflation increases by 4.5%, then salary growth or other sources of income must exceed 4.5%. Otherwise, the adjusted return would be negatively impacted, reducing savings and investments.
How is inflation measured
There are many countries in the world, and each has its own way of defining how much inflation is considered healthy for its economy. They also have different perspectives and methods for measuring inflation.
In the case of Western countries, which are more developed compared to emerging economies like India, the approach differs. For example, if we talk about developed economies like the USA, they also use specific measures and targets to monitor inflation.
Consumer price index (CPI) – how it is calculated
Most countries use the Consumer Price Index (CPI) method to measure inflation. If we talk about a country like the USA, the target inflation rate is around 2%, as set by the Federal Reserve. When inflation rises above or falls below this target, the central bank takes appropriate actions to stabilize it.
Similarly, in the case of India, the target inflation rate is around 4%, as set by the Reserve Bank of India (RBI). If inflation moves above or below this target, the RBI takes necessary decisions to manage inflation according to its mandate.
The Consumer Price Index (CPI) includes several components that are calculated to measure inflation. For example, it takes into account food inflation, clothing and footwear, housing, fuel, and other miscellaneous items. All these items are included in a specific basket.
By calculating the changes in the prices of this basket, the CPI determines how much prices have increased compared to a previous period. It is a widely used method across the globe and provides a good and timely indication of inflation trends. This helps policymakers take appropriate measures based on how inflation has moved compared to the previous month.
The CPI has several components, and it is calculated separately for rural and urban areas. It is also revised periodically to reflect changes in consumption patterns. For instance, the base year and components were different in 2004, and the CPI was last updated in 2011. These changes are made based on the recommendations of the relevant committee.
What steps can be taken to control inflation
High inflation is considered harmful to the economy, so several measures are taken by the Monetary Policy Committee (MPC) of the RBI to control it. One of the most commonly used tools is the repo rate. The repo rate is a key instrument used by the RBI to manage inflation.
When the RBI increases the repo rate, it usually indicates that inflation is high or expected to rise. By raising the interest rate, borrowing becomes more expensive. As a result, people and businesses tend to borrow and spend less. With reduced demand, the prices of goods and services may decline, helping to bring inflation under control.
This approach to managing inflation through interest rate adjustments is commonly used by central banks around the world.
By using the repo rate, the RBI aims to manage liquidity in the market to ensure healthy economic growth. When growth is adjusted for inflation, it reflects the real progress of the economy. Therefore, maintaining a balance between inflation and growth is crucial.
Apart from the repo rate, the RBI also uses other monetary tools such as the Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), and Standing Deposit Facility (SDF) to manage liquidity and control inflation. These tools help regulate the money supply in the economy.
By adjusting these measures, the RBI ensures that people spend more on essential and meaningful goods rather than on unnecessary items. This helps reduce excess demand, which in turn helps control inflation. These strategies are widely used because they tend to deliver effective results.
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How Inflation impact Affects the Stock Market
Inflation has a significant impact on company revenues, profitability, and margins. Initially, moderate inflation appears beneficial for economic growth, as rising prices of goods and services increase corporate profit margins. Higher margins lead to increased profitability, which positively affects employment rates, tax revenues, and credit flow—ultimately contributing to economic growth.
However, when inflation exceeds a certain threshold (e.g., above 6% in India, which is higher than the RBI’s target), it can erode savings and hinder growth.
Example:
Consider Ramesh, who earns a monthly salary of Rs. 40,000. His expenses are as follows:
Rent: Rs. 10,000
Household expenses: Rs. 8,000
Bills: Rs. 3,000
Children’s fees: Rs. 6,000
Other expenses: Rs. 3,000
Savings: Rs. 10,000
If inflation rises, all expenses increase. His total expenses of Rs. 30,000 may rise to Rs. 35,000, reducing his savings to Rs. 5,000. Savings play a crucial role in driving consumption and investment. A decrease in savings results in lower economic growth. Hence, high inflation is considered detrimental to a country’s economy.
In times of high inflation, luxury items and non-essential goods are often the most affected in a competitive market. This is because people tend to prioritize essential and lower-cost products over unnecessary or high-end items. During such periods, central banks may also implement contractionary policies, which further reduce consumer spending power. As a result, the demand and sales for luxury goods usually decline.
