Nobel Laurette Milton Friedman summarized the effect of Inflation on the general populace as “taxation without legislation.”
The past week a leading English newspaper had a headline that people can’t even afford to have a headache in Sri Lanka as even over-the-counter medications like aspirin are in short supply.
What is Inflation?
Inflation is that leak in your wealth that erodes the power of money over time. For example, if today one could buy 1 unit of an item (goods or services) for say 100 ₹ and if in 12 years the same unit of item costs 200 ₹ then the Inflation during the same period was around 6%. So, one must try to beat Inflation to preserve their wealth for future use.
When do we face inflationary pressure?
By classic textbook definition, demand-side triggered Inflation happens when too much money is chasing too few goods. This is because the supply cannot keep up with demand, and the prices go up. Such types of Inflation are controlled by governments worldwide by reducing the money supply.
This could happen through central banks such as RBI (Reserve Bank of India), US Fed, etc. by raising the Repo Rate* so that the money supply is reduced by making it unfavorable for commercial banks like HDFC Bank, SBI, ICICI Bank, etc. from borrowing money from central banks and then lending it to retail or commercial borrowers. As interest keeps rising through repo rate increases by central banks, the demand slows down as the interest outgo for borrowers goes up.
Alternatively, a supply-side disruption or depletion could also lead to Inflation which could be a short-term phenomenon like the impact of the flood on vegetable prices or a long-term phenomenon like the impact of the depletion of oil reserves on long-term crude oil prices.
Such Inflation is addressed by finding an alternative to the goods or services or alternate sources of supply. Like in the case of crude oil, if prices go up a lot in the short term due to supply disruption from a particular source of supply, it could be sourced from alternate sources of supply. Also, alternative sources such as ethanol, renewable sources of energy, or electric cars for a long-term solution.
How much Inflation could be expected in our lifetime?
Former RBI Governor Raghuram Rajan stated in 2014 that the long-term policy objective of RBI is to aim for a real interest rate (= Repo Rate – CPI-based Inflation^) of 1.5 to 2 percent. Afterward, a Monetary Policy Committee (MPC) was set up in 2016 by an act of Parliament to deliberate and provide a recommendation to RBI Governor every quarter about Repo Rate. Additionally, the MPC was tasked to keep the inflation rate between 2 to 6 percent.
However, the recent pandemic has thrown a spanner in controlling Inflation. Due to this, RBI has kept the repo rate as low as 4% since May 2020 to stimulate the economy while avoiding demand destruction due to lockdown and other such measures. Even though the CPI-based Inflation is higher than the Repo Rate in the same period by 1 to 2 percent. That has led to a negative real interest rate of -1 to -2 percent. This is not sustainable in the long term, and the market participant has expressed the same by quoting a higher price for Govt bonds during a recent auction by RBI in the recent past.
Keeping this recent phenomenon aside, it would make sense to follow the que from RBI or MPC with the stated objective of keeping long-term Inflation within 2 to 6 %. So, a 6% inflation assumption while planning for various goals barring education and healthcare goals is something that looks reasonable.
* Repo Rate – at which the central bank of a country (Reserve Bank of India in case of India) lends money to commercial banks in the event of any shortfall of funds.
^ CPI-based Inflation – the average change in prices over time that consumers pay for a basket of goods and services in % terms.