What is Inflation?

Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time.

Wikipedia

Inflation is a hidden expense that all of us have to pay. Just try to remember the prices of ordinary goods when we were kids and compare them to today's prices. The difference is very huge. I vividly remember paying 400 rupees per month as my school fees. Today it costs more than 5000 per month for the same school. Similarly, prices have increased for every other aspect of our life, like food, transportation, housing, etc. This gradual increase in consumer product pricing is inflation.

Inflation is a reality, and we have to accept it. Below are some examples of historical price increases in a few of our daily consumption items.

Inflation in Cutting Chai (Tea)

Let's compare the price of a simple cutting chai. Around 15 years back, the price of a cutting chai was 3 rupees, while today it is about 8 rupees. The price rise might not seem much to us today, but it has grown with a compounded annual rate of nearly 7 percent.

Inflation in Maggi

Around 15 years back, a 100gm Maggi packet used to cost ten rupees. Today the same pack costs 17 rupees, which shows that the inflation in a simple 100gm packet of Maggi has been around 3.6 percent.

Inflation in Sharing Auto-rickshaw

Almost all of us have shared an auto-rickshaw in our daily travel to work. It used to cost 3 rupees to travel from my home to the railway station in my childhood. Today it costs 10 rupees to make the same journey. The cost for the same trip has compounded by 8.36% in the last 15 years.

Historic Inflation in India

CPI stands for Consumer Price Index. This index tracks the price change in a basket of retail products according to their basket weight. In simple terms, it calculates the average price increase in a group of retail products according to their importance. It doesn't take into consideration the prices of services like an AC repairman or a maid or even what we pay for an auto-rickshaw or taxi.

The below table shows the CPI inflation rate of India over the last twenty years.

As you can see above the inflation rate is not constant every year. It changes according to economic conditions for that period. But on average it goes in an upward direction.

Effect of Inflation in Future

Now that we understand how inflation affects us, we have to also understand how the value of money would decrease in the future compared to today.

When we think of the future, we think in terms of today's prices without considering the effect of inflation. We have to ask the questions in the following direction: "If something costs X today, how much would it cost in the future?"

One lakh rupees is still a significant amount in India. Considering the inflation rate of 5 percent for every year, this is how the cost of one lakh would diminish over 25 years.

This chart shows that we would require about 3.5 lakhs to support a similar lifestyle in 25 years that we can do today in 1 lakh. That's the power of inflation. It compounds and decreases the value of our money. We cannot only put our money in a savings account or an FD and be done with it. We have to invest our money in a way that its value increases more than the inflation rate.

Inflation is a beast who would kill our money if we ignore it. The stock market has historically given higher returns than inflation. I am not talking about recklessly investing in stock tips but to buy an index fund that tracks the overall market. Investing in equities is an essential part of our financial plan if we intend to beat inflation over the long term.