Inflation Watch

We keep hearing that inflation is not a concern to the Federal Reserve and Administration officials.  However, I am starting to see some troubling signs.  If you are buying gasoline or groceries you probably have noticed that prices are rising.  What is happening?

• U.S. consumers prices for the month of February, 2011 were up 2.11% on a year over year basis compared with February, 2010.  This is not terribly concerning but it still is above the Fed's informal inflation target of 1.5% to 2.0%.
• However, the CPI rose 0.5% in February on a month-to-month basis.  That is 6% on an annualized basis.
• Many believe that the CPI understates inflation.  For example, around 40% of the index is based on housing costs which have been falling recently.  However, most people are not enjoying reduced costs from housing because they are locked into a mortgage payment that does not change.  Similarly, utility costs and property taxes are not going down.  To see how the CPI calculation can distort the index consider that between 1994 and 2006 the increase in housing in the index was up just 36% even though the average cost of housing doubled.
• At the end of February, corn and wheat prices were up 80% from a year ago.  Soybeans were up 40%.  Hog and cattle prices are at all time highs.  All in all, food prices had the largest one month increase since 1974.
• Cotton prices are at $2.05/lb. compared to less than .80/lb. a year ago.   The average price over the last decade has been about .60/lb.  It takes about six months for cotton to go from the mill to the retail rack.  What you are buying today was made when cotton was less than half of what it is costing the apparel maker today.  Look for higher prices later this year.

Underlying all of this incipient inflation is the near-zero short term interest rates and the massive increase in the money supply engineered by the Federal Reserve.  See my post, Robbing Savers To Pay Goldman, Chase and Citi et al? 

Where does this all lead?  No one really knows as we are in uncharted territory.  However, it appears to be an extraordinarily RISKY policy.  I might add that the risk is mostly yours.  Inflation could actually be the government's best friend.  See my post, The Money Illusion.

Consider these comments by hedge-fund manager Paul Singer in this article in last weekend's Wall Street Journal.  Singer correctly called the sub-prime mortgage meltdown in 2007.  He fears another credit meltdown triggered by current monetary policy.

Monetary policy "is extremely risky," he says, "the risk being massive inflation."

Central bankers, particularly at the Fed but also in Europe, "seem to be acting as if they have unlimited flexibility to ease monetary policy," he says. 

He specifically targets the Fed's "unprecedented" policy of sustaining near-zero interest rates and its exercise in money-printing, "Quantitative Easing 2," that has it buying medium- and longer-term securities from the Treasury. "In effect they're treating confidence in fiat money—in paper money—as inexhaustible, that it's a tool that's able to be used not just in the throes of crisis," but also as "a virtually complete substitute for sound fiscal, regulatory and taxing policy."

Fed officials, he adds, "really seem to think that inflation is something they can deal with very easily and very quickly. I don't believe they're right." He notes that, in the late 1970s, inflation was only in the high single digits yet curing it required interest rates of 20% and a collapse of the bond market.

What can yo do to protect yourself? Gold, silver, oil, the Brazilian real, emerging markets, TIPS? These are on some lists. For the near term, the safest advice I can give you is to load up on Wheaties, cotton goods and toilet paper. Little downside. Upside looks pretty good right now.  They all look like they could be heading higher in price.