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Ride the Inflation Train

By Bryan Perry

History would strongly suggest that we make sure we pay close attention to the important inflationary signs that are forward-looking, and ignore those signs that reflect what has already happened.

One thing we should be aware of is that statistical measures of inflation, like the CPI, are very slow to react. And they reflect average prices across the whole economy.

When there is inflation, many prices don't adjust immediately -- like those affected by the wages for union workers under long-term contracts. So even though the CPI's current 5.6% ought to be alarming -- in and of itself -- it actually tends to underestimate the real inflation that's building, but which has yet to reflect the entire price structure of the economy.

What makes sense for us is keeping tabs on those measures that closely correlate to inflation, because they react to current conditions on a daily basis and reflect the true big picture for inflation.

One such measure is the value of the U.S. dollar on foreign-exchange markets.

Inflation Indicators

Throughout history, when the U.S. dollar falls, it's been a precursor of the inflation to come. The dollar has fallen 40% during the last five years; now it's as low as at any time in the past decade, and there is little to get in the way of the dollar trading even lower.

Another measure of inflation is the price of commodities, especially gold. Studies show that gold is very highly correlated with future inflation, as measured by the CPI. At today's gold price of approximately $900 per troy ounce -- more than double its lows of five years ago -- the CPI can be expected to hold at between 5% and 7%. And at that rate, it still doesn't include the food and energy components. Toss in food and energy, and things get even nastier.

At present, the Fed must keep interest rates artificially low in order to pump life back into the ailing credit and housing markets, but it's playing a dangerous game, given the rising tide of costs.

The bond market has been stable -- with historically low interest rates persisting throughout the recent uptrend of the PPI and CPI -- but remember that throughout most of the '70s, when inflation was turning into hyper-inflation, the 10-year Treasury bond yields never correctly anticipated the inflation that was about to hit.

Simply speaking, the Fed needs to raise interest rates as more and more evidence of inflation hits the tape. And I think it will eventually need to make up for lost time with larger rate hikes than just a quarter-point at a time, as has been its favorite move. Some things don't change, and if the inflation genie is let out of the bottle, then it won't take much more to prompt a gaggle of economists to start shouting the "R" word from the rooftops.

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Bryan Perry is Editor of The 25% Cash Machine.