Inflation Risk

Inflation risk is the erosion of the value of money which results in a reduction in the value of long-term investments. Inflation risk becomes a cause of concern mainly for money market instruments since the returns are so low that they can cancel out any potential gains over time. In this article, we will understand the inflation risk meaning, its various types, their impact and how to manage them.

What is inflation risk?

Inflation risk means reduced purchasing power. The same amount of money that could buy you things today will buy you fewer things in the future as prices increase.

Hence, it is also known as purchasing power risk. It results in the erosion of money in an economy over time. Inflation risk can be caused by multiple factors like changes in demand, changes in the supply of money, or simply cost-push factors.

This makes it important for individuals, institutions, analysts, investors, governments, and economists to understand its nuances to manage their decisions better and make sustainable policy decisions.

Understanding the meaning of inflation risk with an example

Inflation risks reduce the real value of money over time as the prices of goods and services steadily rise in an economy as the years go by.

Understanding how to mitigate the risks by diversifying and selecting the right financial instruments is paramount for all vigilant investors. Let us understand inflation risk with an example and also learn how to calculate it.

How to calculate inflation risk?

Assume you have a sum of Rs. 50 lakh in initial savings, and you plan to save an additional Rs. 5 lakh every year for the next 20 years. You aim to save enough to buy a property that currently costs Rs. 2 crore. The current inflation rate is 5% per year.

Initial scenario

Current property price: Rs. 2 crore

Your initial savings: Rs. 50 lakh

Annual savings: Rs. 5 lakh

Future property price after 20 years:

With an inflation rate of 5%, the future price of the property can be calculated using the formula:

Future price of property = Current Price × (1 + Inflation Rate)^Number of Years

Future property price = Rs. 2 crore × (1.05)²⁰

Future property price = Rs. 5,30,66,000

Future value of initial savings = Initial Savings × (1+Annual Growth Rate) ^ Number of Years

Future value of initial savings = Rs. 50 lakh × (1 + 0.05)²⁰

Future value of initial savings = Rs. 1,32,66,500

Future value of annual savings = Annual Savings × [(1+Annual Growth Rate) Number of Years −1] / Annual Growth Rate

Future value of annual savings = Rs. 5 lakh × [(1+0.05)^20 −1]/0.05

Future value of annual savings = Rs. 1,65,33,000

Total Future Savings After 20 Years:

Total future savings = Future value of initial savings + Future value of annual savings

Total future savings = Rs. 1,32,66,500 + Rs. 1,65,33,000

Total future savings = Rs. 2,97,99,500

Inflationary risk on the price of the property

The price of the property will rise to Rs. 5,30,66,000 while your savings amount to Rs. 2,97,99,500 in the next 20 years keeping in mind the inflation rate This highlights how inflation risk can influence long-term financial investment planning. To meet this goal, you might have to increase your savings, work on the timeline, get a higher initial saving, or combine all three.

Types of inflationary risks

There are two major types of inflationary risks:

• Anticipated inflationary risk

• Unanticipated inflationary risk

1. Anticipated inflationary risk

Anticipated inflationary risk is when it is expected that prices of goods and commodities will rise over time and the purchasing power of money will reduce with time. Hence, it is factored into the pricing of commodities and services with the help of strategies, such as indexing and hedging.

2. Unanticipated inflationary risk

Unanticipated inflationary risk is when a price rise is sudden and unexpected. It can lead to a significant loss in purchasing power and can be harmful to an economy.

Measurement of inflation risk

Here are two of the most commonly used measurements of inflation:

1. Consumer Price Index (CPI): Tracks changes over time in the prices of baskets of consumer products and services

2. Producer Price Index (PPI): Tracks changes in the cost of goods and services received by a producer over time.

These indexes are important for investors and policymakers as they guide their decision-making.

Factors affecting inflation risk

Multiple factors play a role in increasing inflation risk. Some of them include the following:

1. Fiscal and monetary policies of the government

The fiscal (taxation and government spending) and monetary (interest rates and supply of money) policies of the government can increase or decrease inflationary risk.

If the policies are expansionary, the risk of inflation increases as both the demand and supply of money in the market increase. However, if fiscal and monetary policies are contractionary, they reduce the demand and tighten supply, leading to a decrease in inflationary risk.

2. A change in supply and demand

Inflationary risk is significantly affected by market demand and supply. Demand-pull inflation leads to an increase in the demand for goods and services, with the supply being constant, leading to an increase in price.

On the other hand, cost-push inflation leads to an increase in the cost of production of goods, such as increased prices of raw materials and labour, making the product more expensive for the end consumer.

3. Economic conditions across the world

Global economic conditions, like exchange rates and commodity prices, influence inflation risk. A depreciation in currency increases inflation risk by making imports more expensive, while a stronger currency helps lower it. Rising commodity prices can also elevate inflation risk, whereas falling prices will help mitigate it.

Advantages of inflation risk

• Inflationary risk can lead to more spending in the present as the prices of goods and commodities are rising. People would want to spend more in the present instead of waiting for a further price increase in the future.

• A moderate increase in inflation risk allows businesses to adjust their prices in line with rising input costs, such as raw materials and wages.

Causes of inflationary risk

Here are some of the factors that can amplify inflationary risk.

1. Monetary policy

Excessive money supply growth from central banks can devalue currency and increase prices

2. Exchange rate fluctuations

Depreciation of the national currency increases the cost of imported goods.

3. Government spending

High levels of government expenditure can boost demand and lead to higher prices.

4. Supply chain disruptions

Interruptions in supply chains can reduce supply and increase costs.

5. Commodity price increases

Rising prices of key commodities (e.g., oil, metals) elevate production costs.

How to manage inflation risk?

Here are some strategies you can employ to mitigate risks posed by inflation:

1. Indexing

It helps businesses to keep up with inflation by adjusting their prices. For example, the salaries of workers can be adjusted to keep up with inflation so that their income remains the same and does not decrease due to the reduction in the purchasing power of money.

2. Diversification

This is one of the most popular strategies among investors, as they spread their investments across various asset classes like stocks, bonds, real estate, etc. This reduces their chances of risk since they are not too invested in just one instrument.

3. Hedging

In this risk management strategy, investors protect themselves from inflationary risk by investing in things like gold or real estate, which tend to increase in value when prices go up.

4. Inflation-protected investments

Investing in securities like Treasury Inflation-Protected Securities (TIPS) ensures that investments keep up with inflation, maintaining their real value over time.

5. Avoiding excessive debt

Individuals and businesses should always aim to pay off debt as quickly as possible and avoid taking high interest loans to protect themselves from inflationary risks that might cause interest rates to skyrocket.

Disadvantages of inflation risk

• Inflation risk drives up the costs of goods and services, impacting businesses by either reducing customer purchasing power or squeezing profit margins when costs can't be passed on.

• Inflation risk erodes the purchasing power of savings, leading to lower real income levels and hindering the achievement of financial goals.

• Businesses face higher borrowing costs due to inflation risk, as lenders demand compensation for the risk of lending and the diminishing real value of money over time, affecting investment decisions and profitability.

Conclusion

Inflation risk is the loss of value of money over time. It can greatly affect your long-term investment decisions, and hence, managing them effectively by employing measures such as diversification, hedging, indexing, etc. is essential.

Being aware of the various inflationary risks can mitigate the adverse effects of inflation and safeguard your financial well-being.

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