hey guys welcome to another article with me shashank udupa and in this episode we're gonna talk about this very important key financial term known as inflation.
now what is inflation right let me tell you it in a very simple format what is inflation.
hen too much money chases a particular good right it leads to an inflation right if i have to put in a slightly different way inflation basically means an increase in the price of goods or services over a period of time which devalues the purchasing power of money and currency right.
i don't worry i'll explain it more simply with simple terms and with more examples now what do i mean by you know inflation means increase of price of goods and services over time which devalues the purchasing power of money now you might have heard us saying that a lot of our parents keep telling that you know at one point we could buy a particular commodity or we could buy something uh like a samosa for like two rupees or three rupees but now you might need to spend around 10 to 15 or 20 rupees for it
so that basically does not mean that the goods and services have actually become very expensive it also means that the money or the purchasing power of our currency has devalued right so the price of goods and services also have gone up and the price of the purchasing power of our currency has also gone down and that leads to inflation
now to understand this in a more simple term inflation there are two types of inflation the two types of inflation are demand pull inflation and cost push inflation now let me explain both in very simple terms now the first thing is demand pull inflation now demand pull inflation occurs when there is an increase in supply of money and credit in the market if there is more supply of money and credit in the market it stimulates obviously more demand for a lot of goods and services in the economy and that will make the inflation go up automatically why because there is increased demand and that leads to price rise the production capacity might not be so much right but the demand is higher now when does this happen
now for example let's say that you know we want to grow the economy and you know we print a lot of money and we print a lot of money what happens is more liquidity in the hands of common man now what happens is if i want to buy a particular product and you also want to buy a particular product both are willing to pay the same amount for a particular product that means the demand for that product is high but the product capacity is the same it's not going up right
there's only 100 of that product but there are a thousand people who want to buy it so what happened automatically the price goes up of the commodity so that is like an inflation by demand so if there's too much demand right and there's too much liquidity in the country and there is too much demand that is coming out of this liquidity for a same type of product where the production capacity is the same the price usually tends to go up due to inflation number one the second thing is cost push inflation
now this has nothing to do with the demand right cost push push inflation basically means the increase of prices when prices increase but the increase in the production process of a particular company right when the company is trying to produce a particular commodity or trying to produce something and suddenly in the production cost something has gone up because of inflation and obviously if the cost of production goes up the end cost of that particular product will fall on consumers and then we have to pay extra for a particular product right
and that is not because of demand it's not because a lot of people want that particular demand it's because maybe some raw materials have increased in the production process because of inflation and that is why it has been pushed out in the finished product so that is called cost push inflation
now these are the two things that are there with respect to inflation let me make it more simple and let me try to explain it in a more simplistic format just have a look at this image now if you look at the first one which is the blue one which is more demand pool inflation if you look at rising property prices are because increased consumer wealth because increased consumer well means common people have more money and the property prices go up because everyone wants to buy a particular house that is basically too much demand for property
at this point and that leads to a demand pull inflation but or else it wouldn't go up the property price would still be the same but there are a lot of people who have a lot of money and they all want to buy a particular property or in a particular area the inflation of that area goes up and that's because of demand
now if you look at the green part which is more of cost push inflation if you see in the world suddenly oil prices might go up if oil prices go up there are a lot of industries that depend on oil prices to perform now if oil prices go up obviously the cost of doing business will go up because now power and fuel becomes more expensive so higher cost of doing a business now if higher cost of doing a business by the time i finish my final product because the oil prices went up my prices of my final product also goes up right
and because of that it leads to a cost push inflation risk now these are the two main things that happen now let's look at something known as domestic inflation now you understood what is demand pull and cost push now let's look at how domestic inflation correlates with the stock market how domestic inflation and stock market looks like with respect to each other now have a look at the inflation index of india over the last few years in this chart now what you will observe that during the in the last 20 years
if you can see the most inflation period that happened was between 2004 to 2010 look at that entire jump that happened right but in the last few years it has been at around four what the predicting is in the next few years will be around four-ish percent but in 2020 it was at six point two percent but usually most of the time in inflation in india is anywhere between four to six percent
now why am i talking about inflation and white why am i telling you it's so important because when you come when you start investing in the stock market this is where inflation plays right a lot of people when they invest in the stock market they get 12 returns 13 returns and they're very happy no one adds into the cost of inflation because whatever you're trying to buy now might be more expensive by six percent
now inflation is basically a double edged sword it means that means it has two impacts in the stock market it has a positive impact but also has a negative impact now let me explain what the positive impact of na of actually looking at inflation now when inflation goes up okay inflation basically has a nice positive effect on cyclical stocks okay cyclical stocks are those stocks that tend to do well
when the economy is growing and tend to do bad when the economy is falling very simple now usually high inflation periods are usually seen when the country's economy is growing right when the economy is growing that means everyone's spending a lot of money demand goes up and slowly inflation goes up at the same time so what happens is if the inflation goes up then the cost of some commodity stocks will automatically go up because of inflation because demand is high so the commodity stocks go up or if the commodity actually price goes up of the commodity all the commodity stocks will automatically start doing well right
because the price of that particular good which was at say 100 rupees now becomes 120 rupees only because of inflation and what happens is they get more amount of money in their cash flow so it is positive inflation is actually positive when it's com when it comes to high growth of the economy and also works well with commodity stocks that are cyclical stocks
now let's look at the negative effect which is the opposite effect now inflation can sometimes for companies as we mentioned in one of those examples inflation can sometimes play a role in increasing the price of the raw materials that are there in a particular product now if i'm creating a particular product maybe the raw material price went up because of inflation nothing else it just went up because of inflation now if the price of the raw material goes up
i still have to maintain my profit margin so i might increase the cost of my final product little bit more and if i increase that i have to put it back to the customer now the customer might think this is too expensive so when that happens it might have a negative impact on the cash flows of a particular company so that is from a negative impact
now there is a third negative impact and this is very important please understand this there is a third negative impact that in inflationary periods are usually accompanied with something known as interest rates and it's usually accompanied with increased interest rates now let me tell you how this works now basically rbi okay this is done by rbi where they increase the interest rate to prevent inflation from rising more
okay now i'll tell you how this works and why they do it now when interest rate goes up okay automatically investors want more returns from the stock market now what is interest rate now i'll tell you what if the inflation currently let's assume for an example inflation of this year is ten percent okay but your interest rate is currently at six percent okay
interest statements assume i'm investing in a fixed deposit and fixed deposit is giving me six percent but my inflation is ten percent won't you lose money at that point right because if you kept it in six percent obviously you will lose four percent at that point but what i would say is you know what let me go invest in the stock market at least to try and beat the inflation of 10 if the 10 was there
so sometimes what people do or what rbi basically does is that they try to increase the interest rate now the rise in interest rate on debt instruments basically means that investors want more return from equity markets so if the interest rate goes up say for example fixed deposit now gives you eight percent returns then you'll be like okay if interest rate of fixed deposit is eight percent then stock market should now give me at least 12 to 13 because it's more risky
so whenever interest rate goes up people automatically expect the stock market to give more in return and if that does not happen they remove their money from the stock market and put it in the safest in instrument and still get eight percent return and still beat the inflation at the same time so that is how rbi plays a lot to curb the inflation
now if you look at this right from this perspective this is very very very important and i'll tell you why this is so important is because interest rates are extremely crucial when it comes to how the market reacts to it because if the interest rates are not attractive if fixed deposits or debt instruments are not attractive then all the people want to invest in the stock market to get better returns
but tomorrow if suddenly the interest rate becomes very attractive then i would not want to be investing in the stock market i would remove all my money from the stock market and start investing in a safe risk-free rate of return from these fixed deposits and maybe eight percent or nine percent if it ever goes up if rba ever pushes it up but if rbi keeps it low then everyone starts investing in the stock market
so that's why i said it's very important because if the interest rates go up and the safety net for fixed deposits go up then a lot of people will remove their money from the stock market and if they remove the money from the stock market the stock market will fall that is what happens so you need to understand when there are high inflation periods that is why everyone keeps looking at what is the rbi changing the interest rate or is the fed changing the interest rate
now who's fed right let me come to that as well now let me tell you how global inflation not india this is what i spoke about india let me tell you how global inflation and the stock market have something in common that is why whenever the fed rates i don't know whether you have heard of this but we know in the news whenever we see that the fed might increase the interest rates we're all glued to our television to see if they're increasing or they leave it unchanged
i'll tell you why that happens now first understand how printing of money works and why it affects inflation now if you look at all the top countries in the world or top economies in the world right they have resorted to this thing known as monetary easing okay or printing of money since the last financial crisis of 2008 and now what happens when more money comes into the hand of people the demand for a lot of goods will go up right
suddenly everyone has a lot of money to spend demand will go up constantly and if demand goes up it creates a demand inflation risk right that is something that might happen now the main problem with something like this is that immediately after a particular time if a lot of money is printed into the system and a lot of people have more money in their hands it causes a high risk for surge in inflation immediately after a particular time so you'll suddenly see whenever there's a lot of money pumped into the system there is a high possibility that you will see a high inflation rate coming soon right now if high inflation rate happens what did we say right interest rate comes into the picture now if inflation in these countries go up too much it might lead to interest rates if inflation goes up too much interest rate might go up as well right
because people want everyone to start investing and holding their money in that fixed deposit now why u.s comes into the picture or why fed is so important now if there is an inflation in u.s which is growing fast then the fed the u.s fed has no other option but to increase the rates now why is this such a big issue for us right we would keep saying why are we looking at that how does that affect us right now if that happens if u.s increases their interest rate which is completely risk-free and safe
then what happens is a lot of foreign investors who are not investing in us right now are investing in different other countries all these foreign institutional investors big people with a lot of money might just say you know what why am i risking so much and investing in another country for 10 return when maybe us has just given me a risk-free rate of return of 8 or something like that right so whenever there's a risk-free asset or whenever it is safe a lot of people might remove their money from the stock market
and recently in december 2020 fii's foreign institutional investors had 21.7 stake in all the companies listed on nsc okay their entire stake right is more than the retail investors or domestic mutual funds in india so the amount of money that the foreign investors are investing in india is massive so if fiis decide to exit and say i think usa is better for me then the selling pressure can drive the stock prices completely down so this is something that happens
and if they remove the money then a lot of indian investors will start panicking lot of local uh you know diis and the retail investors will start panicking which will push to push the price down even more so now you understood how inflation first you understood how putting more money into the system makes inflation come into the picture and if inflation comes into the picture how interest rates might go up
and how if interest rates go up then it might directly affect the stock market see how you're connecting the dots so now every time you look at more money being printed you should be well aware that is it causing inflation next step you look at inflation you'll be like oh my god the inflation has gone up that means there's a high possibility that rbi or the fed might increase the interest rate and if that happens a lot of people might remove their money from the stock market
and if that happens the stock market will go down and all your portfolio savings might go down slightly so that is why it is very important to understand how inflation works wasn't that amazing did you now understand how inflation works and you know why inflation is so important when it comes to stock market investing so every time if you're investing in something if you're investing in any financial instrument always consider inflation right
if you're saying i'm investing in a particular thing that you know financial instrument and getting only four percent return but inflation on that year is six percent you have actually lost two percent because your currency has depreciated by that much so always make sure that whenever you're investing in something understand how investment works understand how finance works everything in the financial world is connected
and that is why we are educating you to understand how a small thing like inflation it or maybe how somewhere in some other countries printing a lot of money might affect you sitting in india right so this is what we strive to give out as education and i hope you guys like this i hope i could explain this in a very simplified format for you guys and if you liked it as usual please like share subscribe and leave a comment below because i like reading the comments as well and this is me shashankar signing off for today.
**Notice
investments in securities market are subject to market risks read all the related documents carefully before investing please read the risk disclosure documents carefully before investing in equity shares derivatives mutual fund and or other instruments traded on the stock exchanges
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