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March 19, 2011
By Money Morning Staff



  
 

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 ³core 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) ± 

  Executive Editor
William Patalon III sat down with Chief Investment Strategist Keith Fitz-Gerald for a question-
and-answer session on the topic.

   
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"  21.
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.

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 ³official´ 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.

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 21.
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.

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 21.
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 

  and


 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.

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 21.
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-20ƍs 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 ³while 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 ³free´ 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.

 
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 21.
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 ³Team 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 ³stimulus´ that will ±
at least according to theory, anyway ± translate into sustainable growth.

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, ³stimulus´ 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
³contained.´ 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 ³fine´
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 ³withdrawal´ 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 ³sure´ we¶re
on our way. Many market-watchers, analysts and traders ± myself included ± believe this
will inflate another financial ³bubble.´ 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 ³when 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 ³La La Land.´ I submit t hose folks have never been to
Washington.

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 21.
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 ³non-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 ³worth.´
5.| Freeze the budget and allow private sector growth to compensate. Quit trying to ³help´ 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.

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 21.
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:
a|   .
>3;),   ?@A'AB 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%.

a| 3
 
>3C3*!#  ?B5'78 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.

a|  44


3D!#  ?,,8'85: 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.
|