In today's Finshots we see why central banks are being accused of acting too late in their battle against inflation

The Story

On Friday, the RBI raised the repo rate for the third time since April. It has now shot up from a 20-year low of 4% to a whopping 5.40% in a very short span of time.

So why is the central bank in such a hurry to increase rates, you ask?

Well, they’re fighting an uphill battle against inflation.

They are expecting a steep increase in prices and they believe that this price rise will top at 6.7% this year. And they want to use interest rates to contain inflation at this level.

Now if you’re not following all this, it’s okay. We always preface every story on central banks with our 150-word explainer on interest rates.

You see, central banks have one major objective. They’re responsible for keeping prices stable. Otherwise, runaway inflation can hurt everyone — you and me, included. If people have to pay 2 times more for a packet of milk compared to a year ago, they’d be pretty unhappy no? And obviously, no central bank wants people out on the streets with placards castigating them for their incompetence. So the smart people at RBI try to pre-empt such aberrations and use interest rates to keep everything in balance. For instance, when they increase interest rates, it becomes more expensive for people (and corporates) to borrow money. This in turn will push people to tighten their purse strings. The muted spending will have an impact on demand and business owners will likely cut prices in order to stimulate interest once again. In principle, this should help tame prices.

And right now, every central bank is hoping that this playbook will help them mitigate inflation to some degree at least. A couple of weeks ago, the European Central Bank initiated its first rate hike in 11 years. Then last week, the Bank of England committed its biggest interest rate hike in 27 years. Elsewhere, the US Federal Reserve has also raised rates a few times already and they’ve promised that there’s more to come.

Bottom line — Everybody is scrambling to fight inflation.

Now here’s the problem though. Inflation has been lurking in the shadows for over a year now. But when people sounded warnings earlier, central banks simply tossed the memo in the garbage can. They kept saying things like “inflation is transitory”, “this too shall pass”, “don’t worry, it’s only temporary”. You get the drift.

So this brings us to the big question: Why are central banks late to the inflation party?

Well, there are lots of variables that affect inflation. But let’s look at the two main drivers.

  1. There’s demand-led inflation.

Imagine the government puts money in your pocket and tells you, “Hey, I know you’re having a hard time. This should help you tide over the next few days.” Or they dole out money to companies by extending zero-interest loans.

Most folks will spend it, right? That’s simply how we’re wired.

But if everyone goes on a spending spree, the new demand may outstrip supply. And prices may rise.

This is kind of what happened during the pandemic.

But there is also something else

2. Supply-led inflation

For instance, remember when ships were stranded in ports across the world and the global logistics system came to a grinding halt? Well, this affected the supply and movement of goods. And the disruption pushed prices higher. But it didn’t stop at that. The global chip shortage made consumer electronics more expensive. The Russian invasion of Ukraine affected commodities like wheat and oil. The pandemic pushed food prices higher. And while demand remained quite robust, the supply simply wasn’t forthcoming. This pushed prices some more.

Now ideally, central banks should have jumped in at this moment to tame inflation. But experts believe they may have fallen prey to a false sense of security. During the Great Financial crisis of 2008, central banks slashed interest rates and pumped trillions into the economy hoping to stimulate growth. At the time people kept sounding alarm bells just like they did last year. They said — “Will all this excess supply push prices higher?”

“Will this trigger runaway inflation?”

And guess what happened?

Nothing. They kept waiting for a price rise but it never came. So back in August 2020, when the first signs of inflation started showing up, they likely believed that history would repeat itself. That inflation would just go away. But when it kept peaking and began hurting people in a very real manner, they finally had to junk their hypothesis. They had to throw away the 2008 playbook.

But that’s not the only thing. Even though central banks are pushing interest higher each day, that may not get them out of the woods entirely. While interest rates can deal with demand-led inflation, it isn’t particularly effective against supply-led issues. For instance, they can’t churn out more semiconductor chips by fiddling with interest rates. The money is already there. The problem is — It takes a couple of years to set up a fabricator. You can’t expedite this no matter how hard you try.

And as American economist Jason Furman recently wrote, “…inflationary pressures reflect both supply and demand factors, the exact combination of which is unknowable.” Essentially, without really knowing what’s driving inflation, central banks are just using the ammunition that they have and hope it works.

Until then…

Ditto Insights: How to deal with rise in insurance premiums?

Most people think that premiums on health insurance policies remain fixed throughout the policy term. However, that isn’t true. Prices can increase for a whole host of reasons. They can increase on account of inflation. They can increase when you cross a certain age threshold. And companies can also commit changes when their existing pricing structure becomes unviable.

But how do customers preempt this price rise? How do you prepare for such things?

Well, know that insurers can’t increase their premiums willy-nilly. Nor can they enforce a premium hike just to target you as an individual. They have to do it on a collective basis and they have to explain their logic to the insurer. For instance, let’s imagine that an insurer has a price structure that’s totally unviable. They’re selling policies at dirt cheap levels and the claims are piling up. How do you get a whiff of this financial instability?

Well, a little ratio called ICR can help you i.e. Incurred Claims Ratio. You take the total claims paid out by an insurer during the year and then divide it by the premiums they collect during the same period and voila, you get ICR. So if there’s a company paying out ₹120 in claims while only collecting ₹100 in net premiums, you can safely assume that the insurer is losing money. And if this pattern persists, then there’s a very real risk they may go under. So it’s likely that they will rejig their pricing structure. Which means you can expect to see your premiums rise considerably.

How do you tabulate the ICR? Well, you could go to IRDAI’s website and pull up the latest annual report to tally the numbers. Or you could simply talk to our advisors at Ditto and ask them to do it for you :)

P.S. This is a multi-part series where we explain how to mitigate price rises within the health insurance domain. So you can expect to see more tips this week.

Until then...

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