Inflation and the after effects!

We have seen inflation in India going up steadily, driven by higher commodity prices. The last reported inflation is above 7.00% for the week ending April 1, compared to 2.97% in Oct 2007. That is, there is a clear increase of 4 percentage points in inflation over the last 7 months.

In response, the Indian government has freed imports of essential commodities and cut the import duty for several items. The wide-spread expectation is that RBI will hike the Cash Reserve Ratio. This will increase the cost of funds in India with an adverse impact on interest rate sectors like automobile, real-estate and above all banking.

On the other hand, US Fed is fighting real hard to delay the recession, if you believe it is not yet already there. The FED has been aggressively cutting the rates and currently it is at 2.25 %. It is believed that there would be further cuts which would force flight of capital from US to other markets with higher interest rates. If you see the interest rates raising in India, there is a possibility of capital flowing into Indian debt. Of course, there is a exchange rate risk but can't be very adverse if there is more flow of dollars into India. Rupee is going to appreciate against the dollar.

So to summarize the effects of inflation:

1. Interest rates are going to be high in India for at least the next 6-12 months.

2. Inflation is going to be high and leading to higher commodity prices.

3. Debt instruments and markets are going to be favoured compared to equity markets.

4. Rupee may appreciate further and touch Rs38 to a USD in the next 12 months.

5. Equity markets would be subdued and more stock specific.