Okay, so what has inflation got to do with investments? From an investments perspective inflation is particularly important for those who are invested in debt instruments (incl. debt funds). There are several reasons for the same.

We all know that the value of money erodes with time. This phenomenon is the result of inflation  a situation where too much money is chasing too few goods thus resulting in higher prices.

Now when inflation occurs, as mentioned earlier, the value of money invested erodes  this is especially true in case of debt instruments where there is no capital appreciation.

Moreover, to counter inflation, which at higher levels is undesirable, central banks increase the cost of money (i.e. interest rates) so that the demand for the same reduces. Rising interest rates, again, impact the value of our fixed income portfolio adversely.

The impact of higher inflation, in other words, can be significant.

The present scenario in India is one where inflation has been subdued for a prolonged period. This has been made possible due to several reasons

1. The supply of goods has been ample, in fact excessive, leading to excessive competition and lower prices.

2. Food stocks are abundant due to successive normal monsoons.

3. So far, the impact of higher crude prices has failed to filter in.

4. Demand from the industrial sector both for investment and consumption goods has been subdued.

A very idealistic situation, one might say. But will this last?

To answer this, two points need to be considered.

One is whether the sharp firming up of crude prices over the last one month will persist and thereby impact domestic prices. Two, if industrial demand were to pick up, would interest rates continue to remain on a declining trend.

In our view, higher crude prices will sooner or later filter into the economy. Unless of course the Iraqi situation were to dramatically take an about turn. Present indications only point to a worsening of the situation. And as far as an industrial recovery is concerned, it is an eventuality the time frame for which is not certain. But a lot of reports have been indicating that things may be turning around.

If both these events were to occur, there could be an immediate jerk up in the inflation rate and subsequently interest rates. This could see your investments in debt funds taking a hit.

And even if interest rates were not to increase due to other developments, they definitely would not continue to decline at the rate they have been in the last couple of years. This again would hit your expected return.

There is little doubt that over the medium to long term interest rates in the country will continue to be on a declining trend. However, sometimes it may be wise to be aware of near term trends and to make the most of them.

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