Over the last 2 years you would have seen the inflation fluctuating on a monthly basis. In India, inflation is either measured as retail inflation (CPI) or as producer inflation (WPI). From an interest rate perspective, it is the CPI inflation that is more important as it reflects the changes in the cost of living. Inflation impacts your financial plan in a variety of ways as do interest rates. That means you need to adapt your financial plan to shifts in inflation and interest rates. Here is how you go about doing it.
When inflation is trending higher
If inflation is trending higher, the first question you need to ask is whether this is a temporary phenomenon or a permanent phenomenon. For example, inflation shows spurts in certain months due to the base effect. These can be ignored. But, if inflation is going up on a structural basis then you need to tweak your plan. For example, you must have assumed your future goal requirements based on a certain inflation assumption. If the inflation is going to average higher then you must either reduce your eventual goal amount or increase your monthly saving. Also, very high inflation is incompatible with equity market performance and you need to tweak your equity holdings accordingly.
When inflation is trending lower
There are two interesting sides to this argument. Low inflation is good for equities as it means that the real returns on equity are going to be higher. However, you need to be cautious about very low inflation or inflation going into negative territory. Very low levels of inflation or negative inflation are a signal of economic stagnation and that is again negative for performance of equities. These are the times when liquid funds and gold are the best performers. You can look to temporarily tweak your portfolio mix accordingly. Also lower sustainable inflation means that either you are going to have more than your goals or you can start saving less each month.
When interest rates are trending higher
Just as a reasonable level of inflation is required for the markets, a reasonable level of interest rates is also essential for the markets. Japan had zero rate of interest for a long time and during this period the economy hardly grew and their equity markets grossly underperformed. So you do require interest rates above a certain threshold. But the problem arises when interest rates go up too sharply. For example a sharp rise in interest rates leads to depletion in the value of bonds, especially those with a higher duration. So, if rates of interest are raising then it makes sense to shift the debt component of your portfolio from long dated to short dated debt. A higher exposure to liquid funds and short term funds will be a better idea. When it comes to equities, higher interest raters will lead to future cash flows discounted at higher rates. That is negative for valuations of equity.
When interest rates are trending lower
What happens when interest rates are trending down? Firstly, like in the case of inflation, interest rates also should not go too low as to become unsustainable. Otherwise a normal and calibrated fall in interest rates will lead to an appreciation in bond prices which will mean that bond funds with longer maturity will gain more. So you can look to tweak your debt portfolio to include more of long dated securities to benefit from the bond price appreciation. The case applies to equities too. When rates go down, the future cash flows are discounted at a lower cost of capital. That means; your current valuation of equity goes up. This is positive for the equity component of your portfolio. In countries like India, sectors like automobiles, NBFCS and banks put together account for close to 50% of the Nifty. These are all rate sensitive sectors and benefit from lower interest rates. You can position your equity and debt portfolio accordingly in your financial plan.
When real interest rates are falling
Real interest rates represent the difference between the rate of interest and the rate of inflation. This can be expressed as under:
Real Rate of Return = (Nominal interest rate – Rate of inflation)
When real rates go too low, the central bank (the RBI in this case) is inclined to raise the rates of interest. For example, currently the real rate of interest is 1.25% in India whereas the RBI target is 1.75%. That is why the real rates of interest also become critical input points.