Relation between Inflation and Bank Interest Rates: How does Inflation affect rates?

 “Inflation is the overall or specific increase in the cost of goods or services.”

Inflation is an increase in the price of a basket of goods and services that is representative of the economy as a whole.

Inflation is basically a rate of increase in the price of goods and services which in economics defined as “The overall general upward price movement of goods and services in an economy, usually as measured by the Consumer Price Index (CPI).”

In India, however, it is measured using the wholesale price index (WPI).

The CPI is based on a basket of goods and services with different weights, reflecting the expenditure of a typical consumer. The weighted average of price rises of these goods and services gives the inflation figure.

Inflation simply reduces the worth of our money. For example: the same 1 kg of apples you used to buy at Rs. 100 will cost you Rs. 110 next year, if the inflation remains at 10%.

Inflation is when our Mom or Dad complains about the prices they have to pay nowadays compared to what they paid when they were younger. “I remember when a roll of Poppins only cost 20 paise.” “I used to buy Tur dal at Rs.14/Kg.” “When did milk get so expensive?” My Great Grandfather used to get a salary of Rs. 5 per month!!

Most people look at their present living standards and estimate how much they will need to accumulate to survive. They don’t even take a second look at inflation. India’s Inflationrate is currently above 9%. There are no Fixed Deposits which give such high returns. This means that for ever year that your money is in the bank you are actually losing money!!  Inflation is Eroding the value of our money lying idle in Savings Accounts in Banks, as it is fetching us only 4% ROI.

The best way to beat inflation when planning for the future is to include it in your calculations. The biggest problem we see with a lot of long-range financial planning, especially retirement planning, is that people forget to factor in the effect of inflation on their investments and savings.

Another quick way to account for the effect of inflation is to subtract the inflation rate from any rate of interest you will be receiving on an investment. So if you are going to assume a 10% inflation rate and the assumed rate of return is 11%, do the projection with only a 1% rate of return. This will give you a more accurate picture of the value (not the amount) of the investment at its maturity!!!.

If inflation is high, interest rates are increased. If repo, ie rates at which banks borrow from RBI, is increased, such borrowing will become costly and banks would thus either borrow less or pass on this increased cost to their borrowers. Again if reverse repo is increased, banks would divert more funds towards RBI and excess liquidity will be absorbed by RBI rather than going at cheaper cost in the economy. In either of the cases, actual lending will be less and demand for goods and services will be less

In the case of CRR, if the rate is increased, it affects in two ways. First, immediate liquidity in the system is absorbed to the extent CRR is increased as more money needs to be placed with the regulator. Second, in the incremental lending, potential capacity of banks to lend is curtailed. This again leads to less lending by banks.

How is inflation calculated in India?

India uses the Wholesale Price Index (WPI) to calculate inflation. Most developed countries use the Consumer Price Index (CPI) to calculate inflation.

      What is Wholesale Price Index (WPI)?

Wholesale Price Index (WPI) is the index that is used to measure the change in the average price level of goods traded in the wholesale market. In India, a total of 435 commodities data on price level is tracked through WPI which is an indicator of movement in prices of commodities in all trade and transactions. WPI is published on a weekly basis in India.

    What is Consumer Price Index (CPI)?

CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. It is a price index that tracks the prices of a specified basket of consumer goods and services, providing a measure of inflation. In India, CPI is published on a monthly basis.