As concerns amplify on account of rising inflation levels in the economy, all eyes are set on what the government and the central bank (the RBI) will do next. In these circumstances, the government has few options to rein in the inflationary pressures on manufacturers and consumers. Actually, the remedy lies in altering variables on the two broad parametres -- fiscal and monetary. As part of some fiscal measures, the government has already announced reduction in excise and custom duties on key products like crude oil, petroleum products and steel. Therefore, the rise in prices at the consumer level has not been commensurate. Another fiscal measure that could be considered is to raise income taxes so that households have lesser disposable income in their hands, which 'could' then slow down consumption (another way of reducing inflation). However, this is a 'non-populist' measure and the government might not resort to it anytime in the near future.
Thus, this leaves the RBI to take the monetary route and raise interest rates in the economy. There are already clear indications that the RBI, in its upcoming mid-term review of the monetary policy for 2004-05, might resort to hiking the benchmark interest rate (read, bank rate).
What will be the implications? On the consumer side, this move is likely to have short-term implications, as any rise in interest rates might have an affect on the 'sentiment' side. There could be a 'wait and watch' approach, which could slow investment activities and consumption. On the corporate side, demand for credit will slow down and at the same time, the cost of money could increase.
However, one must note that this current inflationary trend is not just unique to India alone, rather being a global phenomenon. For instance, crude prices are determined by international demand and supply dynamics and little can the Indian government do to influence the same.
However, the government can do one thing on its part. The government is the largest borrower in the country. Rising fiscal deficit without an adequate growth in output (productivity per unit of rupee spent) leads to more money chasing fewer goods. This then leads to inflation in the economy. Thus, if the government were to give heed to its fiscal imprudence, cut down on its 'extravagant' and non-productive expenditures, inflation could be controlled without resorting to a high rise in interest rates.
In these times, what should an investor do?
This is probably the most intriguing question that an investor faces in times of rising inflation. One might argue that, in inflationary times, going all-out for investing in equities is a good option as compared to bonds or debt instruments. This is because while returns on debt instruments tend to decline, the real return (adjusting for inflation) from this investment may not be remunerative as well. While equities may not be rewarding in the short-term, over a period of two to three years, the returns are likely to be higher on a relative basis.
But there is a caveat. As said earlier, high inflation tends to erode profitability of companies (or account of reduced margins due to high costs). This might then lead to lower EPS on lower return on investment for investors. Also, if interest rates were to rise as a measure to rein in inflation, aggregate demand in the economy might slow down thus directly affecting the sales of companies. This might then have a negative affect on their stock prices as investors' expectations for faster growth reduce.
As such, a good way to hedge against the perils of rising inflation is to have a diversified portfolio that has a right proportion of both debt and equity. Perhaps the case of equities is strong now and therefore, the proportion could be higher.