Now imagine the stress this puts on the government (remember government pays indexed salaries and indexed pensions) finances. Low real returns has a very bad impact on the investments that people make – and the asset allocation has an impact on the credit market also. So the government has to tackle inflation – in a democracy it has the sure impact of bringing down governments. Unfortunately the government is in a tight spot – as we recently saw the government not knowing whether to appease the cane farmer or the sugar user. It is a tight rope.

The Reserve Bank normally starts putting a ceiling on the interest rates – which further  leads to a more inefficient allocation of assets. Given the amount of international liquidity RBI may not be able to increase interest rates – purportedly done to reduce the inflation within the economy. Also we are in a situation where the banks do not know whom to lend in the productive sector (recently a motoring major was borrowing on a 90 DAY CP at 2.8% p.a. interest).

This makes the banks lend to unproductive sectors like land bank (there is a huge jump of bank credit to the real estate industry). This then raises prices of the houses that you and I have to buy. To buy these houses we have to borrow at higher rates! Easy to appreciate the vicious cycle of inflation is it not!

Industry too is too scared to invest money – being afraid of demand contracting due to price rise. Only the highly skilled people / unionized workers are able to keep pace with inflation. Realistically over the past 3-4 years very few people’s salaries would have raced ahead of inflation, in spite of inflation being at low levels. Most manufacturers and traders have made all their costs as variable as possible. So even the lower end staff have been hit in the take home salary story.

Recently, it has been quite hard not to worry about inflation. Sustained inflation is bad for any economy – it hurts the poor the most. In fact inflation is also called an indirect tax. A friend of mine calls India the dollar economy – rice costs 1 US $, pulses cost 2 US $, most vegetables cost upwards of 1 US $ ! Petrol prices and a few other commodity prices (like sugar) have risen rapidly over the past couple of months while the rupee has gained vis-à-vis the dollar. This is in spite of the fact that we are a controlled economy – the rupee dollar rate as well as the end price of petrol is controlled.

In addition, the spread between Government securities (treasuries) and corporate bonds is almost 5%. This again is unsustainable and the government will have to increase interest rates. India may be the first country to increase interest rates – and this will make borrowing abroad more attractive rather than borrowing within the country.
Governments all over the world worry a lot about hurting growth because of high inflation rates. For example the treasuries in the US are currently available at an annual rate of 0.01% interest (it will take only 7200 years to double your money!). If India were to increase interest rates, people will simply arbitrage the opportunity that is all. You could peacefully borrow in the US and invest it in India.

Amidst all this what are the choices for a retail investor? Should he just watch?