Inflationary expectations

Inflation can be of two types: demand-driven inflation and supply-driven inflation. Say, One year ago you had Rs 1000 to buy 100 items available in the market assuming you are the only person to buy these products. One year later you have Rs 5,000 to buy the same 100 items available in the market. What do you think the price of these items will now be? The prices of these items will now be 5 times more on an average. This phenomenon is termed as demand-driven inflation when too much cash chases too few products. That is to say the demand outstrips the supply. Supply driven inflation is exactly opposite of demand-driven inflation which occurs due to supply constraints of important goods or services. Only demand driven inflation can be tackled by tightening the monetary policy. Therefore, RBI has hiked its key policy rates couple of times this year to rein in the demand side inflation.

So, how is it going to affect inflation in the coming months ? The impact of policy rate hikes takes place with a lag of 6-12 months. Therefore, if RBI hikes the interest rates today; then the inflationary pressures will taper off after 6-12 months. Now since RBI has hiked its policy rates a number of times in the recent past, it is expected that the inflation will decline in next few months. In its annual report, the apex bank has mentioned that inflation will be around 5.5per cent by FY2011. Currently the overall inflation which includes prices of manufactured goods besides, food items stands at about 9.9 per cent. Food inflation has moderated from over 20per cent in December to 10.05 per cent in the week-ended August 14. However, experts believe that price volatility in food items will remain till October when fresh crops arrive in market. Therefore, it is expected that there will be a large dip in food prices after October as kharif harvest would bring down the prices. Now since, food inflation has come down a lot; RBI will focus on bringing down the non-food inflation. It is expected that RBI may increase the CRR from 6per cent. This will further rein in the surmounting inflation in the coming months.

Impact on Household expenses

As monetary policy impacts the consumer with a lag of 6-12 months, the household expenses are expected to move down. Once the skyrocketing non-food inflation tapers off, the household expenditure is expected to move up as demand for manufactured goods pick up. As inflation is quite high, it’s better to save now. Currently, the deposit rates of several banks have been hiked in line with the apex bank’s increase of key policy rates. Therefore, it is advisable to save more at this time. Month of February or March might be the right time to start spending on luxury items once non-food inflation dips.

Impact on borrowers

Although RBI has hiked the key policy rates, the lending rate won’t be immediately hiked. The reason is bankers will assess the current demand-supply before taking a call on lending rate. However, lending rates are likely to be hiked after September or October when the credit demand picks up.

Also, the Base rate linked loans could work out cheaper for borrowers because banks want all its customers to switch to base rate linked loans. Therefore, it is advisable for BPLR-linked loan customers to migrate to the new system.

Car loan, home loans and personal loans are likely to get costlier in the medium term. Further tightening of reins from the RBI will squeeze out the excess liquidity from the system and increase the cost of your loans.

Tips for borrowers

If you are planning to apply for a new loan, apply before these teaser loans expires. Teaser home loans provides attractive fixed interest rates for a period of 1-5 years and then an option to switch over to floating or to remain with fixed rate. Since, the interest rates are expected to move up in the near future, it is advisable to avail these offers.

If you are availing loan under the BPLR regime, then migrate to the new system because banks will hike the lending rate of BPLR linked loans. As all new loans sanctioned after July 1, 2010 have been linked to the base rate, banks are offering customers attractive rates linked to the base rate to woo the existing borrowers.

If you are a businessman planning to invest more in the near future, hold your plans for a while. It’s better to squeeze your expenditure or investment as of now as non-food inflation is still very high and demand for manufactured goods is expected to fall. Wait for the correct time when the demand for goods or services picks up.

Government may plan to cap the education loans at 2per cent over and above the base rate. This move could substantially reduce the funding cost for students who are currently availing loans at rates well above 11per cent under the previous prime lending rate regime whereas the base rate of most of the banks is in the range of 7 – 8.5per cent. Therefore, if you plan to avail a student loan you should opt for a floating rate base rate-linked education loan to avail the attractive rates expected in the near term.