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Inflation is Individual Specific

Looking 15 years ahead, what average inflation rate should one consider for taking decisions that are related to investments or loans (mainly housing loans)?
-Bhargava Handique

Looking 15 years ahead, what average inflation rate should one consider for taking decisions that are related to investments or loans (mainly housing loans)? Or, in other words, what should be the optimum inflation rate for India to achieve sustainable economic growth, considering a time horizon of 15 years?
—Bhargava Handique

While the first part of your question is of direct relevance to investors, the second part seems more relevant for policy makers.

Perhaps, an economist would be more qualified to respond to that part of your query. For an investor, the biggest relevance of inflation should be its impact on purchasing power.

When inflation rises faster than the growth in your nominal income, effectively your real income is falling. In other words, your income would enable you to buy fewer things now than you could earlier.

But how do you measure this inflation? Now, because the basket of goods consumed by an agricultural labourer is quite different from that consumed by somebody living in a metropolis and working in a software firm, different representative indices have to be constructed to capture the effect that rising prices have on your purchasing power.

However, before we focus on the core issue let us cut out the undergrowth. The most commonly touted inflation measure in an economy is that based on the WPI. This inflation measure has little significance for the common investor because the basket of goods is really quite different. And, in any case, as the name suggests these are wholesale prices whereas what you and I pay are the retail prices.

More representative measures are those based on the Consumer Price Index (CPI). However, the CPI is separately calculated for four different groups — Industrial Workers (IW), Agricultural Labourers (AL), Rural Labourers (RL) and finally Urban Non-Manual Employees (UNME).

Even within a group there are regional variations. For example, the annual CPI (UNME) ending August '04 varied in the range 1.0 to 7.6 per cent; with the largest increase being in the case of Chandigarh and the least in the case of Bhopal. Compare this to the WPI inflation measure, which stood at 8.33 per cent for the week ending August 28, 2004.

But even the above measures are at best approximate, because we believe that the rate of increase in prices that any individual faces is unique to him, just as the specific basket of goods that he consumes is unique to him. So each individual should instead try to construct an approximate inflation rate for himself by measuring the increase in cost of consuming the goods/services that constructs his consumption basket over the specified period of time. That is the rate of increase in prices that he has to contend with.

As far as taking investment and borrowing decisions based on the inflation rate is concerned, remember that interest rates keep getting aligned to the medium or long-term inflation rate.

Moreover, rarely will you have to take investment decisions where the interest rates would remain unchanged over that long a period. In case of most long-term investment decisions, like the PPF, the interest rates are reset on an annual basis and this invariably will take account of the inflation rate. On the other hand, the rate of interest charged on your borrowings are usually reset on a regular basis (eg. floating rate loans) or a substantial margin is incorporated in the pricing decision, keeping in mind the potential risk to the lender, to contend with inflation and hence interest rate gyrations.

Given that price rise is a certainty, as an investor our focus should always be to earn at least the rate of increase in prices so that our purchasing power does not get corroded. And to do that we must know the rate of inflation that is specific to us. So it is best that you construct your own inflation index and make that your minimum target return from investment.

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