Inflation creates wealth; don‘t treat it as enemy always

'Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man' said American President Ronald Regan. Though not an economist, he described the feeling of common man in best possible words as far as inflation and its impact are concerned. After all, for a common man inflation is the biggest villain as it silently eats away his purchasing power.

There is a lot of emphasis in managing inflation in the financial planning process. All experts without exception suggest that your investments should be able to beat prevailing rate of inflation so that real return could be generated. In case, investments are unable to beat prevailing rate of inflation then investments make little sense. The process of adjusting inflation is followed when we make investments, so what do we with the inflation when we are borrowers of money in form of home loan and personal loan, two most common example of borrowings.

It is for sure that we cannot adjust inflation to the rate of borrowing straight away like we do in case of investments. This means that if we have borrowed money at 10 percent rate of interest and inflation is 8 percent, then we cannot consider the cost of borrowing as 2 percent, however we do get another form of benefit when rate of interest is high. That rise comes in form of wage hike or salary hike. It is inflation that pushes salary upwards. So while central or state government employees get dearness allowance to adjust impact of inflation, private sector employees get annual increment which generally beats inflation. This means that inflation generally pushes the earning potential of an individual. If you do not believe that inflation pushes wage rate and salary up, look at the data below:

The above data sourced from RBI shows rural wages in India has gone up substantially in recent times and has also been able to beat inflation. Same has been the case with salary and wages in organized sector as well. So it is abundantly clear that inflation pushes, salary and wage rate, but how does this help an individual. Does inflation also help an individual? If so, how?

Let us look at a hypothetical example of a person who has taken a home loan. When the person borrowed, he had an annual EMI of Rs. 2.5 lakhs and his salary was 10 lakhs which means that he was paying 25% of his salary. As inflation went on to increase, after ten years he had a salary of 21 lakhs plus while his EMI was still the same. By now, he was paying just 11.69% of his salary as home loan repayment. While his total home loan liability was same, his effective liability has gone down. 

Since inflation was high during initial years, the rate of interest on loan went up which was nullified by the fall in rate of interest during last five years when rate of interest showed southward movement. So the impact of increase on rate of interest got almost nullified for the borrower. No doubt inflation impact would have been more favouable if the loan was borrowed at a fixed rate. Also, the borrower benefits as the price of the house owned by him goes up because of inflation. In fact, most of the middle class home loan borrowers in India have benefitted because of substantial increase in the price of houses. Thought it may be debated that this increase in notional but there is no doubt that wealth has been created because of inflation. 

Year	EMI	Initial Salary	Inflation (%)	Inflation adjusted salary	EMI as % of inflation adjusted salary
1	250000	10,00,000	8%	1080000	23.14%
2	250000		10%	1188000	21.04%
3	250000		9%	1294920	19.30%
4	250000		8%	1398514	17.87%
5	250000		9%	1510395	16.55%
6	250000		8%	1631226	15.32%
7	250000		7%	1745412	14.32%
8	250000		8%	1885045	13.26%
9	250000		7%	2016998	12.39%
10	250000		6%	2138018	11.69%

This example shows that whenever inflation is high and a person has borrowed funds, his effective payment on loan decreases which goes on to show that inflation has its benefits also. The benefit in this case is to borrower. Inflation is not always the villain but sometimes act as the friend also. The impact of inflation depends on which side of the fence you are. One sad but harsh truth, inflation (combined with manipulation) has been the largest wealth creator for middle class in India which owns some kind of real estate. All those who own real estate (land, house or office) should thank inflation for huge wealth that it has created for them, howsoever notional it may be.