INFLATION V/S INTEREST RATES

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CONTENTS SR.N O 1 2 3 4 5 6 7 8 INTRODUCTION INFLATION CAUSES OF INFLATION INTEREST RATES RELATIONSHIP EFFECTS INVESTMENT STRATEGIES ARTICLE TITLE PG NO 3 4 7 12 13 16 18 22

INTRODUCTION
Interest rates and Inflation rates are very important rudiments in current economy as whole. Now-a-days, you might have heard lot of these terms and usage on inflation and the bank interest rates. Here we understand the relation between inflation and bank interest rates in India. Bank interest rate depends on many other factors, out of that the major one is inflation. Whenever you see an increase on inflation, there will be an increase of interest rate also. Well, coming to the point, we can say that there is a strong correlation between interest rates and inflation. Interest rates reflect the cost of money, such as the rate you pay when you borrow money to buy a house or spend on your credit card. Inflation is the cost of things. The world has seen a dramatic decline in inflation rates in recent decades, but concerns about inflation are still warranting especially in some countries. Evidence is mounting that inflation is harmful to economic activity even at fairly modest rates of inflation because of the way it adversely affects the banking sector and investment. One way inflation might affect economic growth through the banking sector is by reducing the overall amount of credit that is available to businesses. Higher inflation can decrease the real rate of return on assets. Lower real rates of return discourage saving but encourage borrowing. In order to understand the relationship between Inflation and Interest Rates, it is essential that we understand each of the terms in brief which will be explained below.
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INFLATION

A commonly used definition of the word inflation is simply "an increase in the price you pay or a decline in the purchasing power of money thats it. Further, in two ways Inflation can be explained neither mutually exclusive. One way to think about inflation, the increasing cost of things, is too much money chasing too few goods. In essence, this bids up the price of the goods, inflating their cost. The other way for prices to go up could be that production costs go up. A labour union negotiating a contract for a higher wage, for example, could cause the cost of the product the union members produce to increase, or inflate.

Inflation generally means rise in prices. Inflation is an increase in the price of basket of goods and services that is representative of the economy as a whole. In simple words it can be described as increase in the price you pay or a decline in the purchasing power of money .The word 'Inflation' , therefore, refers to a growth or increase in money supply. As one of the important economic concepts, the effects of inflation exert impact both in the economic and social spheres of a nation and on its inhabitants.

Inflation is defined as an increase in the price of bunch of Goods and services that projects the Indian economy. An increase in inflation figures occurs when there is an increase in the average level of prices in Goods and services. Inflation
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happens when there are lesser Goods and more buyers, this will result in increase in the price of Goods, since there is more demand and less supply of the goods.

Inflation has been defined as too much money chasing too few goods. This attributes the cause of inflation to monetary growth relative to the output of goods and services. Inflation is a persistent rise in the general level of prices of all goods and services taken together. A specific price in one commodity may rise dramatically as in the case of oil or gas. But if this specific price is nullified by declines in prices of other commodities, the general price level may not rise at all i.e. there is no inflation. The general level of prices depends on a series of individual price changes and their relative importance some measure of these factors, namely, a price index is required.

Inflation is often reported as a percent change in the overall price level between two periods as measured by a price index. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time. But rise in some individual price index will not result into what is generally meant by inflation, its consequences wont be particularly serious if the change in the price index
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quickly reversed itself and price stability is maintained. To become and remain a problem demanding concern, it should involve a long succession of increases in a price index. Thus inflation can be defined as a sharp increase in the rate of change of a price index above an acceptable level that lasts over a time period long enough to create expectations of its future persistence.

Inflation can be recognized as a combination of 4 factors :

The Supply of money goes up The Supply of Goods goes down Demand for money goes down Demand for goods goes up

Inflation for the month of June surged to 9.44 per cent from 9.06 per cent in May 2011.

CAUSES OF INFLATION

Long term inflation occurs when the money supply (currency and check writing deposits) grows at a faster rate than the output of goods and services. When there is more money available than is needed to accommodate normal growth in output, consumers and businesses want to purchase more goods and services than can be produced with current resources (labor, materials, and manufacturing facilities) causing upward pressure on prices. This is often described as "too much money chasing too few goods.

Over a shorter term, inflation can result from various shocks to the economy. Food and energy price shocks are common examples of this in the U.S. The price of a critical commodity such as fuel may rise suddenly and sharply relative to other prices. Since the market does not have time to adjust other prices downward in response, a short-term increase in overall prices occurs. The rate of inflation is sometimes reported with food and energy omitted so the long-term, underlying (or "core") inflation rate is revealed. There are a few different reasons that can account for the inflation in our goods and services; let's review a few of them.
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Demand-pull inflation refers to the idea that the economy

actual demands more goods and services than available. This shortage of supply enables sellers to raise prices until an equilibrium is put in place between supply and demand. The cost-push theory , also known as "supply shock

inflation", suggests that shortages or shocks to the available supply of a certain good or product will cause a ripple effect through the economy by raising prices through the supply chain from the producer to the consumer. You can readily see this in oil markets. When OPEC reduces oil supply, prices are artificially driven up and result in higher prices at the pump. Money supply plays a large role in inflationary pressure as well. Monetarist economists believe that if the Federal Reserve does not control the money supply adequately, it may actually grow at a rate faster than that of the potential output in the economy, or real GDP. The belief is that this will drive up prices and hence, inflation. Low interest rates correspond with a high level of money supply and allow for more investment in big business and new ideas which eventually leads to unsustainable levels of inflation as cheap money is available Inflation can artificially be created through a circular increase in wage earners demands and then the subsequent increase in producer costs which will drive up the prices of their goods and services. This will then translate back into higher prices for the wage

earners or consumers. As demands go higher from each side, inflation will continue to rise Governments need to control high levels of unpredictable inflation since it can severely disrupt the economy, cause uncertainty in financial decisions, and redistribute wealth unevenly. The tools they have available include:
1. 2.

Monetary policy (increase or decrease the money supply), Fiscal policy (change the amount of taxes and governmental spending), Various controls on prices, tariffs, and monopolies.

3.

Many nations (including the U.S.) choose monetary policy as their primary tool since it has proven to be very effective, it is less disruptive to market operations, and it is easier and quicker to implement since adjusting the money supply does not require legislative approval as would, for instance, changing the tax structure

HOW DOES INFLATION AFFECT THE ORDINARY MAN?

Inflation affects different people or economic agents differently. Broadly, there are two economic groups in every society, the fixed income group and the flexible income group. During inflation, those in the first group lose while those in the second group gain. The reason is that the price movement of different goods and services are not uniform. During inflation, most prices rise, but the rate of increase of individual prices differ. Prices of some goods and services rise faster than others while some may
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even remain unchanged. The poor and the middle classes suffer because their wages and salaries are more or less fixed but the prices of commodities continue to rise. On the other hand, the businessmen, industrialists, traders, real estate holders, speculators and others with variable incomes gain during rising prices. The latter category of persons becomes rich at the cost of the former group. There is transfer of income and wealth from the poor to the rich. More generally, which income group of the society gains or losses from inflation depends on who anticipates inflation and who does not. Those who correctly anticipate inflation can adjust their present earnings, buying, borrowing and lending activities against the loss of income and wealth as a result of inflation. To further determine the effect of inflation on individuals, it will be necessary to discuss the effect of inflation on different groups. a) Creditors and Debtors: When there is inflation, creditors are generally worse off because, the real value of their future claims is reduced to the extent of the rate of inflation. On the other hand, when inflation occurs, debtors tend to pay less in real terms than they had borrowed. Therefore, it could be said that inflation favours debtors at the cost of creditors. b) Salaried Persons: Those with white-collar jobs lose during inflation because their salaries are slow to adjust when prices are rising. c) Wage Earners: Wage earners may gain or lose depending on the speed with which their wages adjust to rising prices. If their union is strong, they may get their wages linked to the cost of living
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index. In this way, they may be able to protect themselves from the negative effects of inflation. Most often in real life there is a time lag between the rise in the wages of employees and the rise in price. d) Fixed Income Group: These are recipients of transfer payments such as pensions, unemployment insurance, social security, etc. Recipients of interest and rent also live on fixed incomes. These people lose because they receive fixed payments while the value of money continues to fall with rising prices. e) Equity Holders and Investors: These group of people gain during inflation as the rising prices expand the business activities of the companies and, consequently, increase profit. Thus, dividends on equities also increase. However, those who invest in debentures, bonds, etc, which carry fixed interest rates, lose during inflation because, they receive fixed sum while purchasing power is falling. f) Businessmen: Producers, traders, and real estate holders gain during periods of rising prices. On the contrary, their costs do not rise to the extent of the rise in prices of their goods. When prices rise, the value of the producers inventories rise in the same proportion. The same goes for traders in the short run. The holders of real estates also make profit during inflation because the prices of landed property increase much faster than the general price level. However, business decisions are difficult in an environment of unstable price. In the long-run, there could be an increase in wages which will reduce profit thereby, having an adverse effect on future investment.
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g) Agriculturalists: Agriculturalists are of three types, namely, landlords, peasant proprietors and landless agricultural workers. Landlords lose during rising prices because they get fixed rents. Peasant proprietors who own and cultivate their farms gain. Prices of farm products increase more than the cost of production. Prices of inputs and land revenue do not rise to the same extent as the rise in the prices of farm products. On the other hand, the wages of the landless agricultural workers are not raised by the farm owners, because trade unionism is absent among them. But the prices of consumer goods rise rapidly. So landless agricultural workers are losers. h) Government: Inflation will have both positive and negative effects on the government. The government as a debtor gains at the expense of households who are its principal creditors. This is because interest rates on government bonds are fixed and are not raised to offset expected rise in prices. The government in turn levies less tax to service and retire its debt. With inflation, even the real value of taxes is reduced. Inflation helps the government in financing its activities through inflationary finance. As the money income of people increases, government collects that in the form of taxes on incomes and commodities. So the revenue of the government increases during rising prices.

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INTEREST RATES

A rate which is charged or paid for the use of money is called the interest rate. An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for deferring the use of funds and instead lending it to the borrower. Interest rates are normally expressed as a percentage rate over the period of one year.

An interest rate is often expressed as an annual percentage of the principal. It is calculated by dividing the amount of interest by the amount of principal. If a business wants to borrow Rs. 1 million from a bank, the bank will charge a specific interest rate that will usually be expressed in terms of a percentage over a given period of time.

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RELATIONSHIP
Interest rates are the rate of interest you receive or pay depending whether you save or borrow money respectively.

The higher the interest rate the more expensive it becomes to borrow money and the more attractive saving becomes.If your bank decided to double the interest rates on your savings account you will be more likely to put more in it, thus the higher the interest rate the more money is restricted from the money supply having an adverse effect on inflation. e.g. If numerous people can purchase the same house, the price of the house is likely to increase because there are several prospective buyers.

In other words, the cheaper cost of money drives up (inflates) the price of the home. Historically, you can plot the correlation

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between interest rates and inflation and see that there is a strong positive correlation between the two. Interest and Inflation are key to investing decisions, since they have a direct impact on the investment yield. When prices rise, the same unit of a currency is able to buy less. Investors aim to preserve the value of their money by opting for investments that generate yields higher than the rate of inflation. In most developed economies, banks try to keep the interest rates on savings accounts equal to the inflation rate. However, when the inflation rate rises, companies or governments issuing debt instruments would need to lure investors with a higher interest rate. Inflation is the rate of increase in the general price level, so a 10% inflation rate means prices overall are 10% higher than a year ago. Interest rates are the cost of borrowing, or the price of money. A 10% interest rate is the return a saver will get, or the amount a borrwer will have to pay, over a year. There are many ways of thinking about the link between interest rates and inflation. The easiest is the one used by the Bank of England. When economic growth is strong, and in particular when spare capacity has been used up - economists say the output gap has been closed - there will be pressure for higher inflation. One example would be that when unemployment is low, additional demand for labour will tend to push up the growth in wages. Interest rates are therefore used to keep growth broadly in line with its long-run trend of 2.5% or so each year. Higher interest
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rates discourage borrowing and encourage saving and will tend to slow the economy. Lower rates encourage borrowing and have the opposite effect Inflation is an autonomous occurrence that is impacted by money supply in an economy. Central governments use the interest rate to control money supply and, consequently, the inflation rate. When interest rates are high, it becomes more expensive to borrow money and savings become attractive. When interest rates are low, banks are able to lend more, resulting in an increased supply of money. Alteration in the rate of interest can be used to control inflation by controlling the supply of money in the following ways:

A high interest rate influences spending patterns and shifts

consumers and businesses from borrowing to saving mode. This influences money supply.

A rise in interest rates boosts the return on savings in building

societies and banks. Low interest rates encourage investments in shares. Thus, the rate of interest can impact the holding of particular assets.

A rise in the interest rate in a particular country fuels the inflow

of funds. Investors with funds in other countries now see investment in this country as a more profitable option than before.
DRAWBACKS OF HIGHER INTEREST RATES:

Business activity in the market slows down. The threat of high interest rates makes individuals and companies defer taking out loans which could have been used to finance a new business or build a house. Less economic activity translates to slower economic
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growth. Slower growth means reduced company investments, less job opportunities for people, or worse, lay-offs of employees.

INVERSE RELATIONSHIP Of course , there is typically an inverse relationship, high interest rates equals low inflation, low interest rates equals high inflation. If there is more money in an economy, people tend to spend more. If there is less money in an economy, there is less to spend and low demand equals lower prices. If interest rates are low, money is easier and cheaper to borrow, hence more money in an economy. If rates are high, it is more expensive to borrow, hence less money in an economy. STAGFLATION:

There is also a concept know as stagflation, when interest rates and inflation both increase, such was the case in the Carter Administration. External market factors or market manipulation may cause stagflation.

EFFECTS
Inflation affects both the economy of a country and its social conditions, as well as the political and moral lives of its inhabitants. However, the economic effects of Inflation are stated and described below:

Price inflation has immense effect on the Time Value of Money

(TVM). This acts as a principal component of the rates of interest,

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which forms the basis of all TVM calculations. The real or estimated changes occurring in the rates of inflation lead to changes in the rates of interest as well.

Inflation exerts impact on the treasury of a nation as well. In

United States of America, Treasury Inflation-protected Securities (TIPS) ensures safety to the American government, assuring the public that they will get back their money. However, the rates of interest charged by TIPS are less compared to the standard Treasury notes.

The most immediate effect of inflation is the decrease in the

purchasing power of dollar and its depreciation. Inflation influences the investments of a country. The Inflation-protected Securities (IPSs) may act as a guard against the loss in the purchasing power of the fixed-income investments (like fixed allowances and bonds), which may occur during inflation.

Inflation changes the allocation of income. This exerts

maximum effect on the lenders than the borrowers at the time of persisting inflation, because the loans sanctioned previously are paid back later in the form of inflated dollars. Inflation leads to a handful of the consumers in making extensive speculation, to derive advantage of the high price levels. Since some of the purchases are high-risk investments, they result in diversion of the expenditures from regular channels, giving birth to a few structural unemployments.

EFFECTS ON TIME VALUE OF MONEY:

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As we all know, the simple meaning of TVM is The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. Price Inflation greatly effects time value of money (TVM). It is a major component of interest rates which are at the heart of all TVM calculations. Actual or anticipated changes in the inflation rate cause corresponding changes in interest rates. Lenders know that inflation will erode the value of their money over the term of the loan so they increase the interest rate to compensate for that loss. Changes in the inflation rate (whether anticipated or actual) result in changes in the rates of interest. Banks and companies anticipate the erosion of the value of money due to inflation over the term of the debt instruments they offer. To compensate for this loss, they increase the interest rates. The central bank of a country alters interest rates with the broader purpose of stabilizing the national economy. Investors need to keep a close watch on interest and inflation to ensure that the value of their money increases over time.

INVESTMENT STRATEGIES DURING HIGH INFLATION AND HIGH INTEREST RATES

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As interest rates fluctuate, investors start exploring new investment opportunities to diversify their portfolio. They usually do so to hedge against the risk associated with their existing investment. Short-term interest rates have been at historic highs for quite sometime and it's expected that rates may go up soon again to curb ongoing inflation. That may worry investors about the value of their investments. Some financial instruments are very much sensitive to the interest rates. When it comes to a rising interest rate environment there are several things to consider. Below are few strategies you can adopt during rising interest rates scenario:

There is an inverse relationship between the interest rates and the price (face value) of the bond. When interest rates go up, the value of the bond go down. The bonds with long-term maturity are more sensitive to rate changes. Historically, rising interest rates have caused the prices of existing bonds to decline because newly issued bonds carry higher rates, which pushes down the value of previously issued securities. Bonds with shorter maturity generate good returns so you can switch your investments in high-duration bond funds into funds with a lower duration and average maturity i.e. short-term bonds. Floating rate funds can be a good option in rising rate scenario. Floating rate funds vary from conventional fixed rate investments mainly on the basis of coupon rate i.e. the coupon
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is revised at regular intervals with respect to change in the benchmark rate. Consequently, if there is a rise in the interest rate, the coupon rate usually reflects this change, thereby securing the interests of investors during rising interest rates. Some of the floating rate funds available in the market are Birla Sun Life Floating Rate Fund, HDFC Floating Rate Income Fund, Canara Robeco Floating Rate Fund, etc. Investing in defensive stocks is also a bull strategy during rising rate scenario. You can buy stocks of the companies that make or sell products that people have to buy no matter what: medicine, for instance, or groceries. Defensive industries such as health care, consumer staples, and agriculture wouldn't affect much during such time in-fact they are dominant players in the market and they usually maintain earnings growth in most economic conditions. So you can buy stocks of such companies. Commodities offer real protection and hedge against high inflation and high interest rate environment. That's because when inflation is surging, price of natural resources like oil, food, and raw materials soar too. And, metals like gold and silver are considered to be as safe haven during such times. With a small stake in commodities -- say, 8% to 10% -- you can lower your portfolio's risk regardless of the economy.

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WHY MUST THE CENTRAL BANK FIGHT INFLATION?

Central banks the worlds over are obsessed about inflation and, therefore, devote a significant amount of resources at their disposal to fight inflation. Hence, the primary objective of monetary policy is to ensure price stability. The focus on price stability derives from the overwhelming empirical evidence that it is only in the midst of price stability that sustainable growth can be achieved. Price stability does not connote constant (or unchanging) price level, but it simply means that the rate of change of the general price level is such that economic agents do not worry about it. Inflationary conditions imply that the general price level keeps increasing over time. To appreciate the need to fight inflation, it is imperative to understand the implications of frequent price increases in the system. Some of these implications include: Discouragement of long term planning; Reduction of savings and capital accumulation; Reduction of investment; Shift in the distribution of real income and consequent misallocation of resources; Creating uncertainty and distortions in the economy.

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To avoid any of the situations above, central banks ensure that the price level remains stable. This is achieved by implementing policies that guard against inflation. Indeed, instability in the general price level undermines the function of money as a store of value and discourages investment and growth Highlights of RBI Monetary Policy Review for first quarter of the financial year FY2010-11: The Bank Rate has been retained at 6.0% Repo rate increased by 25 bps from 5.5% to 5.75% with immediate effect Reverse repo rate increased by 50 bps from 4.0% to 4.50% with immediate effect Cash Reserve Ratio (CRR) of scheduled banks has been retained at 6.0% of their net demand and time liabilities (NDTL) The projection for WPI inflation for March 2011 has been raised to 6.0% from 5.5% Baseline projection of real GDP growth for FY2010-11 is revised to 8.5%, up from 8.0% with an upside bias M3 and non-food credit growth projections for FY2010-11 have been retained at 17% and 20% respectively Mid-quarter review of Monetary Policy to be a regular event beginning from 16 September 2010 In essence the RBI announced no hike in CRR and a 25 bps (bps) increase in Repo rate but a 50 bps hike in Reverse Repo rate was not expected by many.

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The RBI said that the Monetary Policy actions are expected to: Moderate inflation by reining in demand pressures and inflationary expectations. Maintain financial conditions conducive to sustaining growth. Generate liquidity conditions consistent with more effective transmission of policy actions. Reduce the volatility of short-term rates in a narrower corridor.

ARTICLE
Faced with slowdown in credit demand, Indian bankers on Monday urged the Reserve Bank of India to hold the policy rates at the current levels, and sought a clearer picture on the future interest rates. Lenders have suggested to the central bank to pause its rate hike cycle and also urged for a clear forward looking statement on interest rates at the policy review next week, said K Ramakrishnan, chief executive officer, Indian Banks Associations (IBA). He was talking to the media after the customary pre-policy meeting with deputy governor Subir Gokarn, where leading bankers shared views on the interest rates, credit and deposit growth, overall economic growth, stressed assets and other macroeconomic data. The first quarter policy review is scheduled on July 26. New projects are not coming in, and therefore, there could be a sort of slowdown going forward as far as the overall credit demand and credit offtake is concerned, said MD Mallya, IBA chairman and CMD, Bank of Baroda. Since March 2010, the central bank has hiked repo rate (the rate at which the RBI lends funds to banks) 10 times by a total of 275 basis points or 2.75 percentage points, in order to tame inflation. Repo rate currently stands at 7.5%. Bankers said they have not yet decided to revise credit growth target. It is too early to revise credit growth target, said Alok Mishra, chairman, Bank of India.
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The bankers also urged RBI to delay the deregulation of interest rates on saving bank accounts. It is not the appropriate time, said Mallaya.

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