Inflation
A sustained general rise in the price level, which erodes what a rupee buys — and the reason a nominal return has to be deflated before it means anything.
In plain language
Inflation is not one item getting dearer. It is the general level of prices rising, and going on rising.
The consequence is the one that matters for investing: money loses purchasing power over time. At 6% inflation, what Rs 100 buys today will cost Rs 106 next year. A return has to beat that before the investor is any better off.
How it works
It is measured through index numbers. India's policy anchor is the Consumer Price Index, which covers retail prices including services; the Wholesale Price Index tracks goods at the wholesale stage and contains no services at all. Under flexible inflation targeting the RBI is mandated to hold CPI inflation at 4%, within a band of 2 percentage points either side, and raises the repo rate to cool demand when it drifts above.
For a research analyst inflation enters the model from four directions at once: it lifts the risk-free rate, therefore the discount rate, therefore lowers present values; it raises input costs; and it determines whether the company can pass those costs on. That last one — pricing power — is what separates companies that survive an inflationary year from those that do not.
The formula
Inflation rate = (Index now − Index a year ago) ÷ Index a year ago × 100
Real return ≈ Nominal return − Inflation (approximation)
Real return = [(1 + nominal) ÷ (1 + inflation)] − 1 (exact)
A worked example
An investor in the 30% tax bracket puts Rs 10 lakh into a fixed deposit paying 7.2%, with inflation running at 6.1%.
Post-tax nominal return = 7.2% × 0.70 = 5.04%
Real return = (1.0504 ÷ 1.061) − 1 = −1.0%
After a year the account shows Rs 10.50 lakh, and it buys about Rs 9.90 lakh of what the original sum would have bought. The deposit paid interest every quarter and still lost money.
The same force works through the companies being analysed. A paints maker facing input costs up 12% while realisations rise 4% watches its gross margin compress by several percentage points — unless its brand lets it raise prices, which is precisely what the industry analysis was for.
Why NISM asks about it
Chapter 5 (Economic Analysis) covers inflation, its two classic causes and the policy response. Expect the demand-pull versus cost-push distinction, CPI versus WPI, a real-return computation, and the chain from inflation to interest rates to valuations.
Common exam traps
- Falling inflation is disinflation, not deflation. Deflation means prices are actually falling — a different and more dangerous condition.
- The subtraction shortcut is an approximation. At high rates use the exact formula; the gap grows with the numbers.
- WPI contains no services and CPI does, and it is CPI that the RBI targets.
- Inflation transfers wealth from lenders to borrowers where the debt is at a fixed rate — the repayment is made in cheaper rupees.
- It hits valuations twice: once by raising the discount rate, and again by squeezing the margins being discounted.
Check yourself
1.Inflation measured at the wholesale level and at the retail level is captured respectively by:
- a)CPI and WPI
- b)WPI and CPI
- c)CPI and GDP deflator
- d)WPI and PPI
Show the answer
Answer: (b) WPI and CPI
The workbook: "generally, inflation is measured in two ways — at wholesale level in terms of Wholesale Price Index (WPI) and retail level in terms of Consumer Price Index (CPI)."
Option A simply reverses them, which is the single most common error on this topic — remember that C in CPI stands for Consumer, and the consumer buys at retail.
The GDP deflator is not discussed in this chapter at all, and PPI (producer price index) is not a term the workbook uses.
2.Inflation risk is highest in which category of investment?
- a)Equity shares of consumer goods companies
- b)Fixed return instruments such as bonds, fixed deposits and debentures
- c)Physical gold
- d)Real estate held for rental income
Show the answer
Answer: (b) Fixed return instruments such as bonds, fixed deposits and debentures
The workbook is direct: "Inflation risk is highest in fixed return instruments, such as bonds, fixed deposits and debentures, where investors are paid a fixed periodic interest and returned the principal amount at maturity." Both the interest payments and the principal repayment are fixed in absolute terms, so inflation eats them without anything pushing back.
The arithmetic it gives: an 8% coupon against 7% inflation leaves a real return of just 1%. Push inflation to 9% and the real return turns negative — with no default at all.
Option A is the opposite of the truth: "Inflation risk is less for equity shares", because if prices rise, businesses see higher selling prices and higher nominal profits. The Venezuela illustration makes the point — bond investors were nearly wiped out in 2018 while the Caracas index rose over 1000 times. Options C and D are not discussed as high-inflation-risk categories at all.
3.Which inflation index is used for Inflation Indexed Bonds, and which for the Inflation-Indexed National Saving Securities-Cumulative 2013?
- a)CPI for both
- b)WPI for IIBs and CPI for the IINSS-C
- c)CPI for IIBs and WPI for the IINSS-C
- d)WPI for both
Show the answer
Answer: (b) WPI for IIBs and CPI for the IINSS-C
For IIBs: the Wholesale Price Index (WPI) is the inflation measure that is considered for the calculation of the index ratio for these bonds.
For the retail instrument: the bond carries a fixed interest of 1.5% and an inflation rate calculated on the basis of the Consumer Price Index (CPI).
The two using different indices is exactly the kind of detail a 25%-negative-marking paper builds a question on.
How the IIB adjustment works: these bonds have a fixed real coupon rate which is applied to the inflation adjusted principal on each interest payment date. On maturity, the higher of the face value or inflation adjusted principal is paid out to the investors. The inflation adjustment to the principal is done by multiplying it with the index ratio, which is calculated by dividing the reference index on the settlement date by the reference index on the date of issue.
The IINSS-C features: these bonds of 10-year tenor were available to retail resident individuals, minors, HUFs, and charities among others. The interest is compounded every six months and cumulated and the same is payable with the principal on maturity. The fixed rate of interest is the floor and is payable even if there is deflation.
Why such bonds exist at all: debt instruments, being fixed income products, run the risk of delivering negative real returns during high inflation periods.
Where this is taught
- Series XV · Chapter 5: Economic Analysisintroduced here
- Series V-A · Chapter 1: Investment Landscapeintroduced here
- Series X-B · Chapter 4: Retirement Planning Basicsintroduced here
- Series SEBI-ICE · Chapter 2: Key Concepts in personal financeintroduced here
- Series X-B · Chapter 6: Miscellaneous aspects of Retirement Planning
Related terms
- Bank RateThe rate at which the central bank lends money to commercial banks without any collateral, for medium to long term or emergency needs.
- Cost-push inflationPrices rise because of an increase in input costs.
- Demand-pull inflationInflation caused by demand running ahead of the supply available to meet it — too much money chasing too few goods.
- Gross Domestic ProductThe market value of all final goods and services produced inside a country's borders in a period, whoever owns the producer — the standard measure of the size and growth of an economy.
- Risk premiumThe extra return an investor demands over the nominal risk-free rate as compensation for uncertainty about future cash flows — the last and largest block in the required rate of return.
- InvestmentThe current commitment of savings for a defined period, in the expectation of receiving back more than was committed — savings put to work, as distinct from savings merely held.
- Accumulation stageThe working years, in which saving and investment build the retirement corpus — the stage where the ability to take risk is highest and where time, not contribution size, does most of the work.
- Distribution stageThe retired years, in which the corpus built during working life is converted into periodic income — the stage where protecting capital matters more than growing it, because it can no longer be topped up.
- Cost Inflation IndexAn index notified by the CBDT each year, with 2001-02 as the base of 100, used to restate the cost of a long-term capital asset in current rupees so that inflation is not taxed as capital gain.
- Capital appreciationThe gain made when the market value of an investment rises above what you paid for it — as distinct from income, which is the interest or dividend the investment pays you along the way.
- Time value of moneyThe principle that the same sum of money is worth different amounts at different points on a timeline, because money held today can be invested and because inflation erodes what it will buy.
- Real rate of returnThe return on an investment after the effect of inflation has been removed — what the money actually buys more of, as against the nominal percentage the product advertises.
- Inflation riskThe risk that the money an investment pays out will be worth less in goods and services than expected, because prices have risen — highest in fixed-return products and most damaging to retirees.