16 Jul 2017 15:46 IST

Why your inflation assumption needs change

The recent fall in inflation is driven by many structural factors and this should reflect in your financial plans

Can you think of one magic ingredient that makes all the difference to your financial plans? It is inflation.

Consider a simple retirement plan for Sangeetha who is 30 and wants to retire at 60. Her current monthly expenses are ₹50,000 and she wants to maintain her current lifestyle after retirement.

At an 8 per cent inflation rate, she will have to plan for a monthly income of ₹5.46 lakh post-retirement. Assuming a life expectancy of 85 and post-retirement returns of 4 per cent, Sangeetha is staring at a retirement corpus of ₹10.35 crore.

But trim that inflation assumption to 6 per cent, and her monthly expenses reduce to ₹3.01 lakh and her target corpus (assuming a 2 per cent return post-retirement) drops magically to ₹7.1 crore.

In fact, the inflation rate matters not just to the corpus she is targeting, but also to the income growth and returns she assumes while making her plan. Both need to be pegged lower with less inflation.

Sangeetha’s case illustrates that the inflation rate that you assume in your financial plan requires a lot of thought.

It affects not just your target corpus but also the assumptions you make on interest rates, returns and income growth.

Today, in India, most online calculators and advisors use an 8 per cent inflation rate. Where does this rate come from?

Critical to your plans

Presently, India uses the new Consumer Price Index (Combined, 2011-12 base year) series to estimate retail inflation.

But as this index has only a five-year history, most financial planners rely on the older CPI-Industrial Workers that has a longer history.

If you average monthly inflation rates on CPI-IW for ten years (May 2007 to May 2017) you get 8 per cent. This is why most planners use this rate in their financial plans.

But if you track macro data closely, you would know that the CPI inflation rate, which hovered at 9-10 per cent five years ago, has since fallen steeply. In the first six months of 2017, it averaged around 2 per cent.

If you’re thinking of pruning your inflation assumption from 8 per cent to 2 per cent in your financial plans, based on this data, it would be fool-hardy though.

Just as 9-10 per cent was an abnormally high inflation rate for India, 2 per cent is unusually low. The base effect from high food prices last year and bountiful supplies after a good monsoon have contributed to this unusually low rate.

To arrive at a reasonable inflation rate for your financial calculations, you need to evaluate two aspects — whether the recent fall in inflation rates is cyclical (temporary) or structural (lasting), and what is the most likely inflation rate you would face over the medium term.

Structural decline

To answer the first question, a reading of the macro trends suggests that structural factors have been at work behind the global slump in inflation.

One, the years from 2003 to 2011 saw global commodity prices scale record highs on the back of the global commodity ‘super cycle’.

In hindsight, that was clearly a speculative bubble which popped in 2014-15.

The super-cycle was fuelled by rising demand from the emerging markets, particularly China, for both industrial and agri commodities. There were fears that world population growth would out-pace both energy and food supplies.

As speculators hopped on to this bandwagon and global funds discovered this new ‘asset class’, global commodity prices trebled between end-2003 and 2011.

But China’s abrupt slowdown since 2015 popped the bubble and put demand-supply factors back in the driving seat.

Another leg of the commodity boom from 2010 was fuelled by the easy money policies of central banks.

But with the US Fed now on a tightening spree and other central banks running out of fire power, the excess liquidity is now evaporating.

Two, high inflation was powered by soaring oil price too. The rise was driven by the infamous ‘peak oil’ theory, which warned that the world would soon run out of crude oil due to dwindling reserves.

But this has since been rubbished with new technology to unearth shale oil and a focus on renewable energy. In fact, thanks to falling costs for shale exploration, analysts now predict that global crude oil prices may get capped at $60/barrel. Given that India imports the bulk of its fuel needs, this means sustainably lower inflation.

Three, policy changes in India have had the effect of quelling inflation too.

The NDA government has proved to be a far more determined inflation warrior than the UPA government before it. So it has opted for modest increases in minimum support prices for crops, plugged leakages in subsidies and targeted MNREGA payouts — three key sources of high domestic inflation between 2007 and 2013.

RBI targets

Let’s not forget that the RBI too has joined the war on inflation recently. Since 2015, after the new monetary policy agreement, inflation targeting has become the bank’s primary objective.

The agreement requires the RBI to deploy all the monetary weapons at its disposal to contain the CPI inflation rate within a 2-6 per cent band.

If inflation readings exceed this range for three successive quarters, the RBI owes a written explanation to the Centre.

After the implementation of this new agreement, the RBI has displayed extreme caution on inflation and has steadfastly refused to ease up interest rates even under pressure.

All the above factors clearly suggest that we may be witnessing a new normal as far as domestic inflation rates are concerned.

So what should your inflation assumption be? Well, 8 per cent is now too high.

One number that can serve as a goalpost is 6 per cent (the upper limit of the RBI’s target range). Six per cent is also the median rate of CPI inflation India has witnessed over the last 20 years.

But rather than blindly adopting this, you may also like to customise your inflation assumption to your personal spending patterns and financial goals. Services usually see higher inflation rates than goods.

For specific goals such as education or healthcare, it is best to take inflation rates in the specific items.

Finally, as the popping of the commodity bubble has shown us, inflation rates, like other assumptions in our financial plans, need to be dynamically reviewed from time to time.

(The article first appeared in The Hindu BusinessLine.)

Recommended for you