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Ride the Inflation Train

By Bryan Perry

Despite the efforts of producers of goods to keep prices down in a soft economy, inflation at the consumer level is alive and well.

• Total CPI jumped 0.8% from June up to 5.6% year-over-year.

• Energy and food prices drove total CPI, since food accounts for nearly 15% of the index and energy almost 10%.

• The year-over-year core rate bumped up to 2.5% in July from 2.4% in June.

The danger from higher oil prices is that they feed down through the supply chain into businesses, and then to consumers. Everything that requires transportation to get goods or services to market is going to have to pass that cost on to consumers. And high oil prices/higher consumer costs are the concern going forward.

In August 1971, Richard Nixon placed wage and price controls on the economy because inflation had reached a point of perceived national crisis. The feeling was that the prices of everything consumers were buying were spinning out of control, but here's the kicker: The inflation rate then, based on the CPI, was at only 4.4%. Heck, that's lower than today's inflation rate, based on the July 2008 CPI report that said inflation is now running at 5.6%.

So why aren't we going nuts and calling for draconian price controls? The answer is that back in August 1971, the American public was accustomed to no inflation, so when it reached 4.4%, it was a real shocker. Today, we can still remember the hyperinflation that peaked in 1980 at more than 14%, so a rate in the 5% range is now considered fairly manageable.

Just don't make the mistake of thinking that 5% inflation is nominal. As I wrote this in mid-July, the yield on a 10-year Treasury bond was about 4.6%, so that nominal 5% inflation reduces your real interest income by about 12% of the effective yield -- meaning that if you are earning a 10% dividend yield, 5% inflation reduces the effective yield to 8.8%.

Now I bet I have your full attention.

That's a meaningful hit and, unless your wages or retirement income is increasing by 5% or more to offset the haircut you're getting in yield, you are facing a growing dilemma.

But, hey, Fed Chairman Ben Bernanke is now touting that the demand destruction in the United States that's been created by the spike in energy prices and the deterioration in home values will curb future inflationary pressures.

Of course, that was the same pitch we got from the Fed back in 1973 when the term "stagflation" came into being.

Bernanke's pitch brings to mind the 1988 Bobby McFerrin song "Don't Worry, Be Happy."

Does Bernanke know a slowing economy will cause inflation to fall? No, he's guessing. Don't worry, be happy!