What Is Inflation?

In economics, inflation refers to a general rise in the prices of goods and services across the economy over time, eroding purchasing power for both businesses and consumers. In general terms, the dollar (or whatever currency one uses for purchases) will not go as far today as it did yesterday. To understand the effects of inflation, let’s take an example, in 1980, Amul milk cost Rs 8 per litre; by 2022, it has climbed to Rs 63. Inflation has no bondage to price hikes for any single item or service; It refers to a rise in cost throughout a sector such as automotive or retailer – and, ultimately, a country’s economy.

In a country with a healthy economy, yearly inflation is generally around 2 or 3% points, which indicates pricing stability; when it is within the range, it positively affects the economy.

What Causes Inflation?

According to John Tylor, an economist in Stanford, Inflation rises when the Federal Reserve sets too low of an interest rate or when the money supply growth increases too rapidly. There are various driving forces behind inflation:

• Demand-Pull and Cost-Pull Inflation

When there’s an increase in aggregate demand for goods is called demand-pull, and when inflation occurs because of a decline in the aggregated supply of goods or services due to an external factor called cost-pull inflation. 

• Devaluation

Devaluation is when a currency loses its value against other countries’ currencies. Devaluation makes imports more expensive and causes inflation.

• Raising Wages

According to some economists, raised wages can cause inflation as companies raise their goods and service costs to pay their employees higher wages.

Effects of US Inflation on Emerging Nations

As consumers from the US to Britain feel the pinch of the record high inflation in decades, rising energy and food costs are also squeezing household budgets in emerging economies. Last Month, US annual inflation clocked its highest rate in 40 years, whereas Inflation in the UK breached a 30-year high of 5.5%.

By increasing interest rates, the Federal Reserve’s determined to crush inflation, and these raised interest rates are inflicting profound pain on other countries. Pushing up prices, ballooning the size of debt payments, and increasing the recession risks.

Underdeveloped countries often have no option but to pay back loans in dollars, regardless of the exchange rate when they first borrowed the money. Spiraling the US interest rate might set off a crisis in emerging nations. In African countries like Nigeria and Somalia, where the risk of starvation is already dangling, the strong dollar is pushing the price of imported food, medicine, and fuel. The strong dollar is nudging debt-ridden Egypt, Argentina, and Kenya closer to default and threatening to discourage foreign investment in emerging markets like India and South Korea. According to the International Monetary Fund, around 40 per cent of the world’s transactions are done in dollars.

 US Dollar Dominance 

The dollar has reached a decades-long high compared to other countries currency values, like the Japanese yen. The euro, used by 19 European countries, reached 1-to-1 parity with the dollar in June for the first time since 2002. The dollar beats other currencies, including the South Korean won, the Brazilian real, and the Tunisian dinar.

Increased interest rates are pumping up the values of the dollar — the go-to currency for much of the world’s import and export— and causing economic turmoil in rich and poor nations.

Hiking interest rates make the dollar more attractive to investors by ensuring better and more profitable returns. That, in turn, means that investors are investing less in emerging markets, which puts further strains on those economies.   

US Inflation Effects on India

• Impact on Investment Portfolio

Long-term inflation has caused a recession in the US. Striving to bring down inflation, the US Federal Reserve is looking to introduce new monetary policies and increase interest rates. Stock market investors react strongly to changes in key interest rates. Consequently, Indian investors can expect modification in their investment portfolio. Growth stocks are affected by the changes in interest rates as their fund managers use a discounted cash flow model to assign values to these stocks. Fund managers tend to assign a lesser value to growth stocks as interest rates increase.

• Cost of Goods

Price hikes of goods in the US market results in a rise in the prices of these goods imported by India. Apart from commodities like pulses and edible oils, Petroleum and crude oil prices are also affected by US inflation. A hike in the price of energy is a matter of concern for the government as India is a net importer of crude oil and has to pay huge expenses for buying it.

• Investors pull out

With the rise in interest rates, investors will start pulling out their invested amount from riskier investments like equities, foreign markets, and commodities. A flight of foreign portfolio investors (FPIs) from the equity and bond markets could further weaken the Indian currency even as the dollar gets stronger with the rate hikes.

• High inflation will lead to higher imported inflation, meaning that everything that Indian imports will become expensive.
• Advanced Economies might force their central banks to abandon their loose monetary policy.  
• Emerged nations, especially the US, would introduce a tight money policy that involves increasing interest rates to restrict emerging countries from borrowing loans and stimulate savings.   
• Additionally, the Increased Inflation rate might affect Indian firms, who are inclined to shift abroad as they find it costlier to do so. 

In just a matter of time, inflation can cause a dollar to be worth less than it used to be, sinking all consumers’ purchasing power. Consequently, it is required to earn more capital to maintain the same standard of living. 

Some government and monetary policies can also result in either demand-pull or cost-push inflation. It can increase demand when the government issues tax subsidies for numerous products. In case demand is higher than supply, costs could rise. Moreover, stringent building regulations and rent stabilization policies could inadvertently surge prices and form an inflationary environment by passing those costs to people or artificially reducing the housing supply.