Inflation is one of the most powerful and misunderstood forces in economics. Now, here is what most of us don’t realise: Inflation isn’t always the enemy. In fact, a little bit of inflation is actually healthy for the economy. The challenge lies in understanding when inflation helps and when it hurts.
By the end of this article, you will never look at rising prices the same way again.
Inflation Overview
Think of inflation as a slow leak in your financial tyre. Just as a tyre with a small puncture gradually loses air pressure, your money gradually loses purchasing power. The Rs. 500 note in your wallet today will buy less tomorrow, and even less the day after that.
This isn’t because the physical note has changed – it’s because the prices of goods and services around you are slowly but steadily rising.So, what is inflation? The RBI defines inflation as “the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling”. In India, we primarily measure inflation using the Consumer Price Index (CPI), which tracks the cost of a basket of goods and services that represents what an average Indian household purchases.
This basket includes everything from food items like rice, wheat, and vegetables to services like healthcare, education, and transportation.
When the RBI announces that inflation is 2.07%, it means that this entire basket of goods and services costs 2.07% more than it did a year ago. If you spent Rs. 10,000 on these items last year, you would need Rs. 10,207 to buy the same things today.
But inflation isn’t uniform across all goods and services. Food inflation might be running at 3%, while fuel inflation could be at 1%, and housing inflation at 4%. This is why your personal experience of inflation might feel very different from the official statistics. If you drive a lot and fuel prices have been stable, you might barely notice inflation.
The key insight is that inflation is not just about rising prices – it’s about the declining value of money itself. This is why economists often describe inflation as a “hidden tax” that affects everyone, regardless of their income level or financial sophistication.
To understand this better, consider the power of compounding in reverse. If inflation runs at 4% per year, the purchasing power of Rs. 1,00,000 today will be equivalent to only Rs. 96,000 next year, Rs. 92,160 the year after, and Rs. 82,270 after five years.
This erosion happens silently, without any dramatic announcements or visible changes, making it one of the most insidious threats to long-term wealth preservation.
Anatomy of Inflation: How Prices Rise in India
Understanding inflation requires looking beyond the headline number to understand what drives prices higher in the Indian context. Inflation does not happen in a vacuum – it is the result of complex interactions between supply, demand, government policies, and global economic forces.
Demand-Pull Inflation occurs when there is too much money chasing too few goods. Imagine the festival season in India when demand for gold, clothes, electronics, and food items surges. If supply cannot keep up with this increased demand, prices rise.
This happened dramatically during the post-Covid recovery period when pent-up consumer demand had to contend with supply chain disruptions, leading to price increases across many categories.
Cost-Push Inflation happens when the cost of producing goods and services increases, forcing businesses to raise prices to maintain their profit margins.
In India, this often occurs due to rising crude oil prices, since the country imports about 85% of its oil requirements. When global oil prices rise, it increases transportation costs, manufacturing costs, and eventually, the prices of almost everything in the economy.
The ripple effects of oil price increases in India are particularly pronounced. Higher diesel prices affect trucking costs, which impact the prices of goods transported across the country. Higher petrol prices affect commuting costs for millions of Indians.
And higher LPG prices directly impact household budgets. The interconnected nature of the Indian economy means that energy price shocks quickly transmit throughout the system.
Agricultural input costs also play a crucial role in cost-push inflation in India. When fertiliser prices rise due to global supply disruptions or when monsoons fail and irrigation costs increase, farmers face higher production costs.
These costs eventually get passed on to consumers in the form of higher food prices. Given that food accounts for nearly 46% of the CPI basket in India, agricultural cost pressures can significantly impact overall inflation.
Role of Gold, Rupee & More
The relationship between exchange rates and inflation is particularly important for India. When the rupee weakens against the dollar, it makes imports more expensive in rupee terms.
Since India imports a significant portion of its energy needs and raw materials, a weaker rupee can quickly translate into higher domestic prices.
Gold provides an interesting case study of imported inflation in India. Indians purchase about 800-900 tonnes of gold annually, making India one of the world’s largest gold consumers. Since most of this gold is imported, changes in global gold prices and rupee-dollar exchange rates directly affect the cost of gold for Indian consumers.
During periods of global uncertainty or rupee weakness, gold prices in India can rise sharply, affecting household budgets and savings patterns.
Sectoral Inflation Dynamics in India reveal interesting patterns that help explain why different groups experience inflation differently.
Food inflation tends to be highly volatile, driven by monsoon patterns, crop yields, supply chain inefficiencies, and seasonal demand variations. A poor monsoon can lead to crop failures and sharp increases in food prices, while a good monsoon can lead to bumper harvests and falling food prices.
Housing inflation in India is often driven by real estate cycles, urbanisation trends, and government policies. In rapidly growing cities like Bengaluru and Gurgaon, housing inflation can be much higher than the national average due to strong demand from IT professionals and limited land supply.
Services inflation, including healthcare, education, and personal services, tends to be more persistent and is often driven by rising labor costs and quality improvements.
Understanding these different sources of inflation helps explain why the RBI’s job of controlling inflation is so challenging. Monetary policy tools like interest rates are most effective against demand-pull inflation but have limited impact on cost-push inflation caused by oil price shocks or crop failures.
This is why the RBI often has to look through temporary supply shocks while remaining vigilant about underlying inflation trends.
RBI’s Inflation Target: Why 4% Matters
In 2016, India adopted a formal inflation targeting framework, with the RBI mandated to keep the CPI inflation at 4% with a tolerance band of +/- 2%. This means the RBI aims to keep inflation between 2% and 6%, with 4% as the ideal target.
But why 4%? Why not 0% or 2% or 6%? The answer tells us a lot about how modern economies function and why getting inflation “just right” is crucial for India’s economic development.
The choice of 4% reflects a careful balance between the costs and benefits of inflation in the Indian context. Zero inflation or deflation might sound appealing to consumers who are tired of rising prices, but it can be economically dangerous.
When prices are falling or stagnant, consumers and businesses delay purchases, expecting even lower prices in the future. This reduces demand, leading to lower production, job losses, and economic stagnation.
Consider the Japan story. Japan’s experience with deflation in the 1990s and 2000s serves as a cautionary tale of how falling prices can trap an economy in a vicious cycle of declining demand and growth.
In the Indian context, deflation would be particularly harmful given the country’s high debt levels and the need for continued investment in infrastructure and development. When prices are falling, the real burden of debt increases, making it harder for businesses and individuals to service their loans.
This can lead to a debt-deflation spiral where falling prices increase debt burdens, leading to defaults, which further reduce spending and push prices down even more.
Very low inflation (0-2%) can also be problematic because it provides little buffer against deflationary shocks. If inflation is running at 1% and the economy faces a negative shock – such as a global recession, a major crop failure, or a financial crisis – it can quickly slip into deflation.
Also, very low inflation can make it difficult for the central bank to stimulate the economy during recessions, as real interest rates remain high even when nominal rates are cut to zero.
The European Central Bank’s struggles with persistently low inflation in the 2010s illustrate this challenge. Despite cutting interest rates to negative levels and implementing massive quantitative easing programmes, the ECB found it difficult to raise inflation to its target of close to 2%.
This experience influenced central banks worldwide, including the RBI, to ensure that their inflation targets provide adequate room for maneuvering during economic downturns.
Moderate inflation (2-4%) is generally considered optimal for most developed economies. It provides enough flexibility for relative price adjustments, gives the central bank room to maneuver during economic downturns, and is low enough not to significantly distort economic decision-making.
In this range, inflation acts as a lubricant for the economy, allowing for smooth adjustments in relative prices and wages without causing major disruptions to economic planning.
India’s 4% target reflects the country’s specific economic characteristics and development needs. As a developing economy with ongoing structural transformation, India experiences more relative price volatility than developed economies.
The agricultural sector still employs a large proportion of the workforce and is subject to weather-related supply shocks. The services sector is growing rapidly, leading to structural changes in relative prices. The 4% target provides sufficient room for these adjustments while keeping inflation expectations anchored.
The 4% target represented an ambitious but achievable goal that would bring India’s inflation in line with other emerging market economies while acknowledging the structural factors that might keep Indian inflation somewhat higher than in advanced economies.
The tolerance band of +/- 2% acknowledges that perfect inflation control is neither possible nor desirable. The band provides flexibility while maintaining credibility. It recognises that attempting to keep inflation exactly at 4% at all times would require such frequent and dramatic policy adjustments that it could destabilise the economy.
The band also reflects the understanding that different types of inflation shocks require different policy responses. A temporary spike in food prices due to a poor monsoon might push inflation above 6% for a few months, but this does not necessarily require an aggressive monetary policy response if the underlying inflation trend remains stable.
Conversely, if inflation expectations start to drift upward and core inflation begins rising persistently, the RBI might need to act even if headline inflation is still within the target band.
Benefits of ‘Inflation Targeting’
Since the adoption of inflation targeting, India’s inflation performance has improved significantly. From an average of nearly 10% in the decade before 2016, CPI inflation has averaged around 4.5% since the framework’s adoption.
The current inflation rate of 2.07% (as of August 2025) represents the success of this framework, though it also raises questions about whether inflation might be too low and whether there is room for more accommodative monetary policy to support growth.
The benefits of achieving the inflation target extend far beyond price stability. Predictable, low inflation helps businesses plan investments with greater confidence, knowing that their cost structures will not be disrupted by unpredictable price changes.
It encourages long-term savings by ensuring that the real value of savings does not erode rapidly. It protects the purchasing power of fixed-income earners like pensioners, salaried employees, and those living on fixed deposits.
Low and stable inflation also helps maintain the competitiveness of Indian exports by preventing excessive domestic price increases that would make Indian goods more expensive in international markets. It reduces the need for frequent wage negotiations and price adjustments, lowering transaction costs throughout the economy.
Perhaps most importantly, it helps build trust in the currency and the economic system, encouraging long-term investment and economic planning.
Challenges of Inflation Targeting
The challenges of inflation targeting in India, however, are substantial and unique. Food price volatility, driven by monsoon dependence and supply chain inefficiencies, can cause significant fluctuations in headline inflation that are largely beyond the control of monetary policy.
The large informal sector in India also complicates inflation targeting. Many prices in the informal economy are sticky and do not respond quickly to monetary policy changes.
This means that monetary policy transmission – the process by which changes in policy rates affect broader economic conditions – can be slower and less predictable than in more developed economies.
Global factors also pose challenges for inflation targeting in India. As a major importer of crude oil and other commodities, India is vulnerable to global price shocks that can push domestic inflation outside the target range regardless of domestic monetary policy.
Measuring Inflation: CPI Basket & Its Role
The CPI is India’s primary measure of inflation, but understanding how it is constructed and what it includes is crucial for interpreting inflation data and understanding its impact on your personal finances.
Remember that the CPI is not just a statistical construct – it reflects economic realities.
The dominance of food in the CPI basket has major implications for inflation dynamics in India. It means that a poor monsoon leading to crop failures can single-handedly push inflation well above the RBI’s target, even if all other prices remain stable.
Conversely, a bumper harvest can pull inflation down significantly, potentially below the lower bound of the target range.
Regional and Demographic Variations in the CPI basket mean that inflation affects different groups very differently. Rural CPI has a higher weight for food compared to urban CPI, reflecting the different consumption patterns of rural and urban households. This means rural households typically experience higher inflation when food prices rise, but lower inflation when services prices increase.
The implications of this rural-urban difference are significant for policy and politics. When food prices rise sharply, rural households – which are often poorer and spend a larger share of their income on food – bear a disproportionate burden.
This can lead to rural distress and political pressure for government intervention in food markets. Conversely, when services prices rise, urban households feel the impact more acutely.
State-wise CPI data reveals even more granular differences. States with higher food weights in their consumption baskets experience more volatile inflation, while states with higher services consumption see more stable but persistent inflation trends.
For instance, a state like Punjab, with a large agricultural population, will experience inflation differently from a state like Karnataka, with a large IT services sector.
CPI’s Limitations
The limitations of CPI as a measure of your personal inflation experience are important to understand. The CPI basket represents an average household, but your actual spending pattern might be very different.
If, say, you are a young professional spending 40% of your income on rent, 20% on dining out and entertainment, and only 15% on food, your personal inflation rate might be very different from the official CPI inflation.
Consider a typical IT professional in Bengaluru: They might spend Rs. 25,000 per month on rent, Rs. 15,000 on food and dining out, Rs. 10,000 on transportation and fuel, Rs. 8,000 on entertainment and shopping, and Rs. 7,000 on utilities and other expenses.
If rent increases by 10%, food prices rise by 3%, and other categories remain stable, this person’s personal inflation rate would be much higher than someone following the national CPI basket weights.
Quality Adjustments in CPI calculation attempt to account for improvements in product quality over time. When a new smartphone with better features costs the same as the previous model, the statistical agencies consider this a price decline in quality-adjusted terms.
However, these adjustments can sometimes understate the inflation experienced by consumers who do not upgrade to newer products or who value different features than those captured in the quality adjustments.
The challenge of quality adjustment is particularly acute for technology products and services. A mobile phone plan that costs Rs. 500 per month today might include unlimited data, while a Rs. 500 plan five years ago included only 1GB of data.
From a statistical perspective, this represents a massive price decline in quality-adjusted terms. But for a consumer who only uses 500MB of data per month, the price has remained constant while they are paying for features they do not value.
Substitution Bias occurs because the CPI basket is fixed for several years, but consumers change their consumption patterns in response to relative price changes.
If, for instance, chicken becomes expensive, consumers might switch to eggs, fish, or plant-based proteins, but the CPI continues to track chicken prices with the original weight. This can overstate inflation during periods of rapid relative price changes.
In the Indian context, substitution bias can be significant given the diversity of food options and the price sensitivity of consumers. When onion prices spike, households might switch to other vegetables or reduce onion consumption. When gold prices rise, some consumers might switch to silver jewelry or delay purchases.
The CPI does not capture these behavioral responses, potentially overstating the true cost of living increases.
New Product Bias arises because the CPI basket takes time to incorporate new products and services. When ride-sharing services like Ola and Uber became popular, they were not immediately included in the CPI basket, even though they affected transportation costs for many urban consumers.
Similarly, new financial services, digital entertainment options, and e-commerce platforms change how people spend money, but these changes are only captured when the CPI basket is updated every few years.
The rapid pace of technological change in India makes new product bias particularly relevant. Digital payments, online shopping, streaming services, and app-based services have fundamentally changed consumption patterns for millions of Indians, but these changes are reflected in the CPI with a lag.
Understanding Core Inflation helps filter out temporary price movements and focus on underlying inflation trends. Core CPI excludes food and fuel prices, which tend to be volatile due to supply shocks and seasonal factors.
Core inflation is particularly important for monetary policy because it better reflects the inflation pressures that the RBI can actually influence through interest rate changes.
Food price spikes due to poor monsoons or global oil price increases are largely beyond the RBI’s control, but core inflation reflects domestic demand and supply conditions that monetary policy can affect.
The Wholesale Price Index (WPI) provides another perspective on inflation, focusing on prices at the wholesale level rather than retail. WPI inflation often leads CPI inflation, as wholesale price changes eventually get transmitted to retail prices.
However, WPI has a much higher weight for manufactured goods and commodities compared to CPI, making it less relevant for understanding the inflation experience of households.
For individual financial planning, understanding these measurement issues helps you interpret inflation data more accurately and make better decisions about savings, investments, and major purchases.
If you know that your personal spending pattern differs significantly from the CPI basket, you can adjust your inflation expectations and financial planning accordingly.
Why Inflation Matters for Stocks
Higher inflation affects stock prices through multiple transmission channels. When inflation rises, companies face increased input costs for raw materials, labor, and energy. While some companies can pass these costs to consumers through higher prices, others with limited pricing power see their profit margins compressed.
Additionally, rising inflation typically prompts the RBI to raise interest rates, increasing the cost of capital and making fixed-income investments more attractive relative to equities.
The discount rate used to value future cash flows also increases during inflationary periods, reducing the present value of companies’ expected earnings. This theoretical framework, however, plays out differently across sectors and time periods in the Indian context, creating opportunities and challenges for different types of businesses.
The fact is that the relationship between inflation and Indian stock markets has evolved significantly since 2008. While high inflation periods like 2008-2014 demonstrated clear negative impacts on market performance and sectoral rotation, the post-2016 inflation targeting era has created more stable conditions for equity investments.
The key insight for investors is that moderate, predictable inflation (2-4%) can coexist with strong stock market performance, as evidenced by the Sensex’s journey from 26,000 to 85,000 during the inflation targeting period.
However, sectors continue to show differential sensitivity to inflationary pressures, with FMCG and healthcare showing resilience while real estate and banking remain more vulnerable to inflation-driven policy changes.
Looking Ahead: What’s Next in Our Economic Journey
As we continue our exploration of inflation, it is worth reflecting on how this knowledge connects to the broader economic concepts we will explore in the coming weeks. Inflation does not exist in isolation – it is intimately connected to interest rates (which we covered in the first part of this series), employment, economic growth, and international trade.
Next Week’s Preview: In Inflation Part 2 (B), we will look at how inflation does not affect everyone equally, creating winners and losers. It will also tell you how to become “inflation-aware” and protect your wealth.
The Bigger Picture: Each topic of this series builds on previous concepts to create a comprehensive understanding of how the economy works. Interest rates influence inflation, inflation affects unemployment, unemployment impacts economic growth, and growth affects everything from government finances to international trade.
By the end of our 52-week journey, you will see how all these pieces fit together to create the complex but understandable system we call the economy.
Glossary: Essential Inflation Terms
Consumer Price Index (CPI): A measure of the average change in prices paid by consumers for a basket of goods and services over time. India’s primary measure of inflation.
Core Inflation: Inflation excluding food and fuel prices, which tend to be volatile due to supply shocks and seasonal factors.
Cost-Push Inflation: Inflation caused by increases in the cost of production, such as higher wages or raw material prices.
Demand-Pull Inflation: Inflation caused by excess demand for goods and services relative to supply.
Deflation: A sustained decrease in the general price level of goods and services.
Disinflation: A slowdown in the rate of inflation, but not deflation (prices are still rising, but more slowly).
Hyperinflation: Extremely high and typically accelerating inflation, usually exceeding 50% per month.
Inflation Expectations: What people expect inflation to be in the future, which can influence actual inflation through wage and price-setting behavior.
Inflation Targeting: A monetary policy framework where the central bank sets an explicit target for inflation and uses policy tools to achieve it.
Real Interest Rate: The nominal interest rate minus the inflation rate, representing the true cost of borrowing or return on savings.
Stagflation: A combination of high inflation and high unemployment, typically accompanied by slow economic growth.
as a Reliable and Trusted News SourceWholesale Price Index (WPI): A measure of inflation at the wholesale level, focusing on prices of goods traded between businesses.
