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INFLATIONV/S

INTEREST RATES

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CONTENTS

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TITLE PG

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1 INTRODUCTION 3

2 INFLATION 4

3 CAUSES OF INFLATION 7

4 INTEREST RATES 12

5 RELATIONSHIP 13

6 EFFECTS 16

7 INVESTMENT STRATEGIES 18

8 ARTICLE 22

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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 isthe 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.

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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, itmay 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 cheapmoney 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

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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. Monetary policy (increase or decrease the money supply),

2. Fiscal policy (change the amount of taxes and governmental

spending),

3. Various controls on prices, tariffs, and monopolies.

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 fixedincome 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 holdersof 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, theprice 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 seeinvestment 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 orbuild 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:19


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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

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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 suchcompanies.

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 andsilver 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 tounderstand 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 andinflationary 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 tooearly 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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