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Inflation, Interest Rate & Equity Market: Understanding the Basics

Submitted by admin on April 11th, 2024

We make our financial planning while keeping in mind the destination of our journey. We achieve financial independence only when we are no longer worried about our household expenses and meeting our loved ones’ expectations.

However, there are always some unwanted events that force us to re-strategize our financial planning. If you have fallen into hardships, take time to assess the gravity of your specific situations before making a complete overhaul of your financial planning. Sometimes, the situation is trickier than what it is in reality. Therefore, taking a decision without delving deep into the matter will see you jumping from a frying pan to fire.

Inflation

Inflation is one of the most used and abused terms in the world economy. Some experts make it sound like an apocalypse. A close association between inflation and consumption is established and emphasised to convey a message that expensive goods should not be consumed. The pattern is apparently hilarious but highly disturbing. Hence, we need to understand what inflation actually is.

Simply, inflation is a rise in the prices of some commodities and/or services. The Reserve Bank of India applies the metric of Consumer Price Index to track inflation. However, the macroeconomic figure should be thought of with a heavy dose of suspension.

The Central Bank of India uses certain constituents to construct its Consumer Price of Index. The lion’s share of the CPI comes under the category of Food and Beverages. It makes a good 45.86%. Therefore, any abnormal price rise in essential commodities such as potatoes, tomatoes, onions etc will directly affect inflation rate.

A massive fluctuation in a few months is highly unlikely. Fuel and Light inflict a heavy impact on our wallets. Therefore, contrary to what is popularly perceived, a huge hike in petrol prices is unlikely to hit the economy negatively.

Therefore, we can safely conclude that the RBI’s expected inflation rate is different from the inflation rate that we experience.

Interest Rates

When speaking of interest rates, investment professionals refer to the Repo rate declared by the RBI in its Monetary Policy Meeting. The Repo rate affects the interest rate on fixed deposits as well as loans that we obtain for banks for business or buying a bike, car or house.

Inflation rates and interest rate are two independent variables.

When the inflation rate goes up, the RBI usually raises the interest rate. When the inflation rate goes down, RBI prefers to keep the interest rate low.

When inflation gets out of control, the RBI limits money supply in the economy, resulting in people spending less. Or it can start printing more money to be repaid later to avoid currency depreciation.

What are the fundamentals of an equity market?

The equity market will allow you to own a business. For example, if you want to have a share in the growth of Tata Motors, you will buy the company’s shares in the equity market. If you suspect that shares will not appreciate in value any more, you can sell your shares in the equity market.

Today’s investors are withdrawing money from their fixed deposits and injecting it into the equity markets. They rationalise their move by citing the reality that yields from the equity markets exceed interest rates on fixed deposits.

This is the biggest mistake on their part.