How to skirt inflationary pull

ASSET PLANNING

Recently inflation had touched a two-year high of 6.73 per cent and settled down at 6.63 per cent on February 10 2007. Between August and December 2006, it was hovering between 5 per cent and 5.5 per cent.

If you remember a year ago, that is on 11th February 2006, inflation was 3.81 and it has increased by 282 basis points. So we can notice that inflation is slowly moving northwards.

Government is taking measures to control inflation. Previously, India had faced a situation when inflation was two digits and interest rate was also two digits. At that time the real earning of the investor was very low. Even corporate earnings was also less at that time.

We will see what impact it has on our personal finance. But before that I would like to give brief idea about the inflation and about the inflation index.

Inflation rate is based on the index. The most popular measure is (WPI) whole sale price index and is (CPI) consumer price index. As prices of various commodities moves up or down, the inflation also moves up or down.

But it is worth noting here that index contain certain items, which do not impact your daily living and the index does not contain certain items which impact your daily living. So in a real life situation, one may find that inflation at the higher side than the given inflation rate.

Now inflation means if you are able to buy a certain item at Rs 100 now, but after considering inflation of 6.63 per cent, a year after you will to pay Rs 106.63 for the same item. And to stay ahead of such situation you should earn more than Rs 106.63 from your investment.

You can create your own inflation index to know the exact inflationary impact on you. For this you should form an index consisting of the items which impact your daily living. Then by noting down the rise in the prices of such items you can very well know the exact rise in inflation rate, and further on your budget.

Now we will see how it impacts us in various spheres of personal finance.

Interest rate

As the inflation rate increases, the real rate of interest decreases. Though generally the interest rate also moves upward, but the real impact on the interest rate, that is, the real rate of interest is on the downside.

It is worth noting here what is real rate of interest? If r in the interest rate, i is inflation rate then the real rate of interest is (r-i)/(1+i).

Now consider the rate of interest is 8 per cent, inflation is 6.63 per cent and the real rate of interest is 1.28 per cent. So in realty you are earning only 1.28 per cent and not 8 per cent.

Now the important thing, if you had invested in debt securities for long term say for three years or say five years and you are getting interest of 6.5 per cent, then considering this inflation figure of 6.63 per cent, your debt investment will give you negative returns of -0.13 per cent.

So at this stage it is worthwhile to withdrew such investment, and reinvest it at the current interest rate, which would have moved up to, say, for example 8.5 per cent. So in such inflationary situation investors should be alert enough to take such step.

Rebalancing of Portfolio

Further, we had seen that when inflation is moving upward, the real rate of interest is low and the earning on debt instruments decreases. So investors need to rebalance their portfolio and asset allocation strategy.

Especially in case of conservative investors, who had taken maximum exposure to debt securities, because to curb inflation you should possess growth assets in your portfolio and you have to increase exposure to such assets, otherwise inflation will eat up the returns. So investors should increase their exposure to growth assets such as shares, property. Remember in long run shares can beat any other investment.

Now as interest rate rises because of inflation, cost of borrowing also rises, which impact earnings. Corporate's profit declines, and in the same way, the return on capital decreases.

So when there is inflationary pressure, returns from the share investment also declines. Even the dividend payment from companies declines.

Housing Loan

The worst hit are home buyers. In inflationary pressure, prices of everything rise, so do does the interest rate. So house buyers have to face two situations, first, a rise in the house prices and the second, a rise in interest rate on the loan.

So he has to take more loan and has to shell out more amount towards EMI. Even those who had taken housing loan are hit by inflationary pressure and the loan providers increase the rate on the loan, and they have to shell out more amount towards EMI, which may affect their entire budget and overall financial planning.

Measures to be taken at the time of Inflationary Pressure

In case of high inflation regime it is advisable to decrease your allocation to debt instruments and increase allocation to growth assets such as shares, and property. Also do not keep abundant cash in savings account. In a high inflation regime it is not advisable as saving account pays only 3.5 per cent interest. Further if you have invested for long term at lower interest rate, then withdraw that investment and invest afresh at current interest rate. Remember only growth assets can keep you ahead of inflation.