Money Morning Staff Reports

Rising prices are hitting U.S. consumers a lot harder than the U.S. Federal Reserve – or the U.S. government – would have us believe. The government-issued consumer price index (CPI) for January showed that “core inflation” – which includes prices for all items except food and energy – was up only 1% from the same month the year before.

By excluding food and energy prices, as volatile as they may be, the CPI fails to convey the pain that rising prices are inflicting on American households. Indeed, some economists have claimed that the true rate of inflation is closer to 8% or 9%.

To get a true picture of the current inflation situation – and to understand its impact and potential dangers (as well as several investment opportunities) – Money Morning Executive Editor William Patalon III sat down with Chief Investment Strategist Keith Fitz-Gerald for a question-and-answer session on the topic.

William Patalon (Q): Keith, we talk a lot about “hidden inflation.” Is inflation a problem right now? If so, how bad is it? The CPI for January said 1%. Given what we see in the marketplace, it sure looks like a case of hidden inflation. What’s the real rate of inflation right now, and is it at its peak, or are prices going to continue to escalate? What do all the statistics in this accompanying chart (see accompanying info-graphic) say to you?

Keith Fitz-Gerald: Short version? The CPI is a joke. Every American knows that in reality it’s far higher than that based on what they feel in their wallets every day. Even my 8-year-old son, Kazuhiko, was asking me yesterday why the Lego set he’s been saving for is now $33 instead of the $22 he initially spotted a few months ago.

[ad#Google Adsense]My research suggests inflation is really running between 9% and 12%, which is more commensurate with what we all feel in our wallets every day. As for whether or not inflation has actually peaked, that’s a tough call best left to those who deal in “official” numbers – and believe me when I tell you that I’m saying that with all the sarcasm I can muster.

My view is that inflation is very real and it’s already here – despite what those in Washington continue to believe … either because their data is so heavily manipulated or because of their own deliberate ignorance. Using history as my guide, I also believe it’s going to get a lot worse before it gets better.

Q: What are the big inflationary catalysts right now? And what’s driving them?

Fitz-Gerald: I think there are a few, but the single-most-important contributory factor is the trillions of dollars central bankers around the world have pumped into the financial system since the crisis began in late 2007. Never mind that the crisis was caused by too much money to begin with; the central bankers have embarked on a course that ultimately risks destroying the very wealth they are trying to preserve.

Granted, 99% of Americans won’t see or believe that because the markets have rebounded significantly as part of the reflation process. But they will definitely feel it.

The only reason we’ve been able to stave off complete inflationary disaster so far is that we’ve exported it to places like China, India and Brazil as part of our monetary policy, in exchange for the cheap goods we’ve come to depend on. However, that’s coming to an end as those economies grow and begin to struggle with inflationary pressures of their own.

Eventually, inflation will come full circle and when there is no place else for us to export it, there’s going to be hell to pay.

Q: How about the Middle East violence and uncertainty? How is that contributing to this?

Fitz-Gerald: Inflation was already well under way before the powder keg there exploded, so this is not as much a primary inflation driver as most people think. That’s not to dismiss it, because there is a direct relationship between scarcity and higher prices especially at the consumer level.

The key is time – and by that I mean time as in how fast prices climb and how long they stay at elevated levels.

Most companies are prepared to absorb short-term volatility. But longer-term, there is no doubt they’ll pass along to consumers (you and me) the higher fuel and petroleum costs that are part of their manufacturing processes. Many, like airline and transportation companies, are already doing so. So are food suppliers and materials makers, for example.

I’ve noticed, for example, a dramatic price rise in what it takes for me to get home to Japan, or anywhere in the Pacific Rim this spring. My breakfast costs 60% more now than it did three years ago and my wife makes no bones about mentioning by just how much the cost of salmon has risen at our local Costco (Nasdaq: COST). Many readers have probably noticed similar things in their own lives.

But, getting back to the Middle East … the risk there is that the unrest that’s right now confined to a couple of countries spreads to the greater region … where we’re talking about 60% of the world’s oil supply being potentially at risk. I’ve diligently prepared our Money Morning and Money Map Report readers for this over the past 12 months and we’ve already profited significantly from our actions. But – and I can’t say this strongly enough – the game is just getting started.

Q: What’s the end-game here? By that I mean, what’s the potential fallout? Could it stall the recovery? With unemployment still up in the 9% neighborhood, are we in danger of experiencing a 1970s-style period of “stagflation?” If that occurs, what’s the outcome you see there?

Fitz-Gerald: I don’t think the end game is as clear-cut as many people would like to believe.

On one hand, the laws of money are immutable, so we will have to pay the piper, but let’s not forget we have virtually the entire G-20’s banking apparatus playing against that possibility. They’re obviously well-intentioned. But it’s all theory. T hey are complete economic morons when it comes to real money.

That’s a strong statement, so let me give you an example. New York Fed President William Dudley recently told business leaders that inflation was not a big deal, especially food inflation. He noted that people forget that even as food prices are rising, other prices are falling and mentioned the new Apple Inc. (Nasdaq: AAPL) iPad 2 as an example … which elicited guffaws from much of his audience – and downright angered the rest who challenged him by asking how long it’s been since he actually went shopping.

Dudley then went on to say that “while rising prices are giving some of you [audience members] headaches, they are not likely to lead to a sustained rise in inflation to levels inconsistent with our dual mandate.”

I’m not sure these guys are on the same planet as the rest of us.

By removing the freedom to fail and, instead, insisting on bailout after bailout, our leaders are propping up zombie financial institutions that will ultimately come back to haunt us. History shows unequivocally that we cannot live on “free” money forever. And it’s worth noting at the risk of sounding like a broken record that no nation in recorded history has ever bailed itself out by debasing its currency on anything other than a short period of time. That’s never happened – and it’s not likely to.

Q: It seems to me that the U.S. Federal Reserve, which contributed to this escalation in prices with its “QE” policies, is now stuck between a rock and a hard place. The longer it maintains current policies and keeps rates at historic lows, the worse price escalation will get. But if it turns off the spigot, it risks shutting off the recovery, too. Is that how you see it?

Fitz-Gerald: I see it that way, too. By keeping rates so low for so long, the Fed is not only risking inflation, but the catastrophic collision of entitlements – like Medicare and Medicaid – to the tens of trillions related to everything from mortgage debt to personal credit cards.

I think it’s a financial deathtrap, for lack of a better term. What “Team Bernanke” is doing is locking down the short end of the yield curve while leaving longer-term risks to the markets in an effort to revive consumption, inventory build-out, and other short-term “stimulus” that will – at least according to theory, anyway – translate into sustainable growth.

[ad#article-bottom]The problem with this is twofold. First, as long as the U.S. is in the driver’s seat, Bernanke can get away with it. But we now have nations like China calling their own shots [that are] increasingly unwilling to submit to Washington’s policy missives. Second, “stimulus” spending – as Washington has defined it – doesn’t work.

If it did, our economy would be screaming along at 8%, or more. Instead we’re like a 1970s Pinto limping along on three cylinders and risking an explosion if we get rear-ended.

In financial terms, the rest of the world is losing faith as reflected in the premiums they’re now attaching to the debt they purchase. And that makes sense for the following four reasons:

  1. The Fed missed this crisis-in-formation, and even in late 2007 insisted that everything was hunky-dory. My favorite was Bernanke who fabulously stated that the risks were “contained.” And we can see how accurate a call that proved to be. So if you’re tempted to put your faith in Team Bernanke, ask yourself this: Given this earlier miscue, why would we believe the Fed will be able to spot the turning point when everything is “fine” and back off the quantitative easing accordingly, which is one of the central bank’s key arguments for taking the actions that it has taken?
  2. Our financial markets have gotten hooked on super-low interest rates in much the same way someone gets hooked on drugs. Just think about what happens when you take away the narcotics … history suggests we’ll see the same “withdrawal” in the financial markets when cheap money gets taken away. From a political standpoint, this is a real time bomb: There will be untold pressures to make sure things are really recovering before the Fed raises interest rates. Of course, what this means in practical terms is that the Fed will keep rates too low for too long – and make too much money available – until it is “sure” we’re on our way. Many market-watchers, analysts and traders – myself included – believe this will inflate another financial “bubble.” Truth be told, I think the central bankers have already done that.
  3. An increase in interest rates will be the financial equivalent of a self-inflicted wound. It will dramatically increase our refinancing costs as borrowing costs go up. In very real terms, this will mean that banks have to potentially pay more on their deposits than they make from their investments as rates rise. Bear in mind that the Fed actually needs low rates to pay for all the debt it has pumped into the financial system. In that sense, rising rates will be like the adjustable mortgage from hell as the federal government struggles – and has to make tough choices – in an effort to service this debt.
  4. And finally, don’t forget that t he Fed has been buying trash as part of the bailout process – mortgage-backed securities, swaps, worthless bonds and other unconventional debt conjured up by investment banks – from Wall Street and from other parts of our economy. And while our central bankers may believe that they will be able to easily sell these assets “when the time comes,” that clearly won’t be the case. Think about it. Those assets will be worth less because a.) their value moves opposite interest rates, meaning any increase in rates will drive down their value, and b.) these assets were junk to start with. The banks that offloaded it to Uncle Sam are all too glad to be rid of it and I can’t think of any reason why they’d take it back.

Folks often refer to Hollywood as “La La Land.” I submit t hose folks have never been to Washington.

Q: I’ve asked you this type of question before, and you always seem to have a great response. So I’m going to pose it again. If President Barack Obama and U.S. Federal Reserve Chairman Ben Bernanke hired you to help the U.S. government arrest this rise in costs, what advice would you provide? What strategy would you employ?

Fitz-Gerald: I think the path here is very simple. But it won’t be popular. And it won’t be painless. I would tell the administration to:

  1. End the bailouts and stop printing money. You cannot suspend free-market forces and still have the economy function. If a company is going to fail, let it fail.
  2. Outlaw “non-deliverable” credit-default swaps to remove the speculative component from the debt market. By doing this, we will shift the focus of the economic recovery from Wall Street back to Main Street – where it belongs.
  3. Start to raise interest rates immediately – before the market does it for you. If you wait for that to happen, you’ll not only lose control of your domestic destiny, you’ll lose what little global respect this economy still commands.
  4. Partially tie our currency to oil and commodities – a move that’s important because it will remove the uncertainty about what the U.S. dollar is actually “worth.”
  5. Freeze the budget and allow private sector growth to compensate. Quit trying to “help” us and get out of the way.
  6. Simplify the tax code and flatten it out so that everyone contributes equally. The U.S. tax code is 8 million lines long … need I say more?
  7. Make it easier to start a business. Give people a reason to put their money to work and an environment that makes hiring people cost effective and not punitive.
  8. Address Social Security – privatize it if you have to – and Medicare while you’re at it.
  9. And, finally, restructure the system in a way that encourages ownership and equity, instead of the current one that encourages people … and companies … to borrow money at seemingly ever-increasing levels. It’s time to acknowledge reality.

Q: Lastly, given what you see for the markets, could you give investors a couple of ideas as to how they should invest – both to protect themselves and, even better, to profit?

Fitz-Gerald: You bet. In my talks around the world, I like to remind investors of an important point – it’s kind of a mantra of mine: Chaos is actually opportunity in disguise. Washington is creating chaos – but from that we’ll see many wealth-building opportunities arise.

For investors, the key thing to do in the years to come is to make investment choices that can weather the storm, and profit from the opportunities that emerge. Here are some very sound choices for turbulent times:

  • Altria Group Inc (NYSE: MO), recent price: $24.43: Altria is a giant cigarette producer with a 6.23% yield that’s a smart choice in rough markets. You may not like smoking any more than I do, but t he firm’s beta is a very low 0.47, which means the stock is slightly less than half as volatile as the broader markets. Operating margin is a healthy 39%.
  • Ecopetrol SA (NYSE ADR: EC), recent price: $39.70: Ecopetrol is a vertically integrated oil company that’s based in Colombia. That makes it a play on Latin America’s robust growth – with a nice 2.5% dividend, to boot. This stock has a beta of 1.01 – which means it’s about as volatile as the overall markets. However, I’m willing to overlook that volatility, since the company’s five-year Price/Earnings/Growth Rate (PEG) ratio is 0.53 which suggests there is still good value at a fair price.
  • iShares Barclays TIPS Bond Fund (AMEX: TIP), recent price: $110.09: This exchange-traded fund (ETF) invests exclusively in Treasury Inflation Protected Securities (TIPS). W hen inflation really blooms, so, too, will its share price. The yield is still 2.4%, which is not much in the scheme of things but given its ability to help hedge off rising prices, I’ll take it.

— Money Morning Staff

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Source:  Money Morning