Three Ways to Profit in the Face of Surging Inflation

By Martin Hutchinson
Contributing Editor

When he slashed the Federal Funds Rate by three-quarters of a percent in an emergency move Tuesday morning, U.S. Federal Reserve Chairman Ben S. Bernanke said he "expected inflation to moderate in coming quarters."

It's quite beyond me why he has such an expectation: Commodity prices have zoomed since he began cutting rates last September, the dollar has been weak, and inflation appears to be on the rise worldwide. Perhaps what Bernanke actually meant was that he knows what reported inflation will be. But he won't be able to tell you what inflation actually is.

You see, the inflation figures you read about are not at all what they seem.

Greenspan, Volcker and Bush ...

Back in the early 1990s, the Fed and its chairman - Alan Greenspan - had a problem. And it was a big one. The central bank tried to maintain a low rate of money supply growth, as Fed predecessor Paul Volcker had pioneered, but this was causing problems. Even though inflation appeared under control, economic growth remained stuck in low gear - even long after the nadir of the 1990 recession. President George H.W. Bush was seriously annoyed, as he had right to be: After all, that slow economic growth probably cost him the 1992 election.

Accordingly, Greenspan in 1993 abandoned monetary targeting, asserting that for some unspecified reason [but one that was doubtless highly technological] money supply aggregates had become inaccurate, so it was better to target inflation directly. However, inflation showed signs of turning up, so in 1994, the Fed was forced to tighten again, slowing growth once more. No fun at all.

The solution was to move the goalposts. The Bureau of Labor Statistics, which measures inflation, suddenly found a great interest in "hedonic pricing" - essentially an assessment of the pleasure people gain from the goods and services they consume.

The idea behind this is quite simple - essentially that the satisfaction derived from a particular good does not remain the same if the quality increases through better technology. Shouldn't that quality increase be counted as the equivalent of a price decrease?

The Numbers Game

The most exciting application of this premise was a concept called "Moore's Law" in the high-tech sector, where microprocessor power was doubling every two years or so. If you pretended that this doubling in chip speeds also doubled "hedonic" output, you could also pretend that the price had been halved. If you then rebased all weightings on the 1st of January of each New Year, you could then take the effect of these repeated "halvings" in tech-sector hedonic prices. If each halving took the tech sector from 5% to 2.5% of the economy, then after 10 years you would have halved prices over fully 50% of the economy.

Doing this is completely spurious - for one thing, it ignores the negative hedonic effects to consumers of such nuisances as customer call centers and automated telephone systems - but it has allowed the BLS to report inflation at about 0.8% to 1% less than it otherwise would have been in every year since 1995.

Conversely, since inflation is lower, using that artificially lower number to get a "real" economic growth figure will produce a growth figure that is artificially higher. And that's why we had the so-called "boom" of the late 1990s, and the apparent boom since 2000 - even though neither really seemed to make consumers any richer.

Needless to say, politicians love this stuff! It enables them to trumpet the new, higher growth rates and the new, lower inflation rates every time they run for re-election.  It also makes improvements in the U.S. economy look much better than its European Union and Asia counterparts, which haven't adopted "hedonic" pricing.

But the game may finally be up. Even hedonic consumer price inflation is running at 4.1% in the last 12 months, so with interest rates at 3.5% for the benchmark Federal Funds Rate and about 3.6% for 10-year Treasuries, interest rates are now significantly below the inflation rate.

That means savers are getting an even worse deal than they usually get.

It also means inflation is almost bound to accelerate. By definition, if borrowing costs are less than zero, people will find ways to borrow and will waste the money they have borrowed. Unless the BLS finds some new trick to avoid reporting inflation, it is likely to rise rapidly towards 10% or so in the months ahead.

Outmaneuver Inflation

For investors, that's not a disaster. In a strongly inflationary environment, there are several potential ways to profit.

Here are three market rules to follow, as well as the profit plays to make [or avoid]:

  • Don't Take "TIPS:" Treasury Inflation Proofed Securities, or TIPS, are one investment to avoid right now. The U.S. Treasury introduced these in 1997 - just after the BLS adopted hedonic pricing - and it has been passing them off as inflation hedges ever since. Because of hedonic pricing, they're anything but that ideal hedge. Yields are very low, and even lower when you look at them in relation to "true" inflation rates.
  • Fly Inverted: The Rydex Inverse Government Long Bond Strategy C Fund (RYJCX) is a fund designed to move inversely to Treasury bonds; it has thus been a terrible investment as T-bond yields have trended steadily downward and prices upward. But it may be ready to come into its own. Remember: the crisis in financial markets caused by resurgent inflation is likely to hit the Treasury market first, so this Rydex "inverse" fund should correspondingly benefit.
  • Go for the Gold: Specifically, invest in the StreetTRACKS Gold Trust (GLD), which is about the most efficient way of getting a pure gold play that you'll find. So bizarre is the world that we live in that gold - at a price below $900 an ounce - is beginning to look cheap. Remember: Back in 1980, during the country's last major bout of inflation, gold achieved a peak that in today's money would be worth about $2,200 an ounce.
  • Jump on Japan: Although inflationists were pressuring it to do so, the Bank of Japan did not cut interest rates on Tuesday. Japan's stock market has fallen about 16% this year, and that makes no sense, given that the country is incredibly liquid, and that its domestic businesses are enjoying a robust economic recovery. Go for the SPDR Russell/Nomura fund (JSC), which invests in smaller Japan-based companies that have little or no exposure to the global-export markets.

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