What to do When the Federal Reserve Finally Gets Serious about Inflation

By Martin Hutchinson
Contributing Editor

The U.S. Personal Consumption Expenditures deflator, believed to be the primary gauge of inflation for U.S. Federal Reserve Chairman Ben S. Bernanke, rose 0.8% in June. That wiped out the gains from the June infusion of tax rebates and turned the key Personal Consumption Expenditure – which had risen a solid 0.6% in cash terms – into a feeble 0.2% drop in real terms.

It’s obvious that inflation is continuing its inexorable increase. It’s also obvious that the world’s monetary authorities – including the Federal Reserve – are going to have to get serious about this potentially ruinous trend.

For long-term investors, all of this leads to a single conclusion: It’s time to get prepared.

The policymaking Federal Open Market Committee meets today (Tuesday), and is expected to keep the Federal Funds target rate at its current level of 2.0%. Even if the FOMC surprises the market and raises the target to 2.25%, that would still leave short- term interest rates about 3% below the current (actual) level of inflation.

In short, this wasn’t a serious attempt to slay the inflationary dragon.

A real such attempt might, however, have a useful effect on global commodity prices. When you look at a graph of commodity prices over the past year, it becomes very clear that their vertical ascent was ignited at just about the time that Bernanke began cutting interest rates last September.

As the Federal Funds rate was cut from 5.25% to 2%, oil almost doubled in price and overall commodities prices shot up by about 40%. Since interest rates stopped dropping at the end of April, commodities prices have stabilized and indeed oil prices have backtracked from their record high of about $145 per barrel to about $120 per barrel.

Even the start of a monetary-tightening cycle would very likely cause a reversal in commodities markets, with speculators closing off their positions and prices dropping back toward their long-term-trend levels – even if the continued demand growth emanating from the emerging markets prevents them from dropping back all the way.

That, in turn, would be immensely helpful to the global economy; after all, even oil at a $100 a barrel – a level first reached in January, just months ago – still seems like a faint-and-withering dream.

High Inflation and Loose Monetary Policy

Of course, inflationary pressures and a need for tighter money are not exclusive to the United States. Even in Japan, which for a decade has worried about falling – not rising –prices, inflation has reached 2%. That’s above the 1.53% yield on Japan’s long-term government bonds, and is well above the Bank of Japan’s policy rate, which has been stuck at 0.5% for the last 18 months.

China and India both appear to have double-digit inflation – as well as interest rates well below the inflationary level.

China is not yet admitting its true level of inflation, since it wants to present a rosy picture for the Olympics, but the first statistics released after the Olympics conclude may be grim.

As for India, it is fighting inflation not by monetary means (The Reserve Bank’s interest rate is still only 8%, compared to inflation’s 12%), but by subsidizing the price of oil, food, and other basic goods. And those subsidies are causing the country’s budget deficit to spiral out of control – it almost equals 10% of India’s GDP.

In Europe, the European Central Bank (ECB) has made fighting inflation its top priority. At 4.1% in July, compared to the ECB’s policy interest rate of 4.25%, inflation is far above the ECB’s target of 2%. In Britain, the Retail Price Index (the one the government hasn’t fiddled with) is currently up 4.6% over the past year, although the Bank of England has managed to keep interest rates positive in real terms at 5%.

A few countries are fighting inflation vigorously. In Brazil, where retail price inflation is around 6%, the central bank interest rate is 13% – producing mouth-wateringly tight money that will allow the domestic economy to grow even after the commodities boom (from which Brazil generally benefits) has turned down.

However, countries with positive real interest rates, which allow them to fight inflation, are few and far between. At the other extreme, you have monetary basket cases like Dubai, where inflation is 22%, but you can get a home or a commercial real estate mortgage at a fixed rate of 7%. This has naturally led to a gigantic construction boom that could end cataclysmically.

Nevertheless, the global picture is clear. In the United States and worldwide, inflation is reaching levels at which policymakers are forced to pay attention. Their first steps will doubtless be inadequate, since rate-setters remain concerned about recessionary risks, and global interest rates will mostly remain negative in real terms. At some point, however, the gradual tightening of monetary policy will bring an end to the commodity price bubble.

Where to Be When the Fed Gets Serious

When policymakers finally start raising interest rates and the commodity cycle turns downward, stock markets will initially be adversely affected. The shares of oil companies and commodity producers will drop, and other shares will remain affected by the likelihood that higher interest rates will translate into lower profits. But there are two clear investment groups that are poised to benefit:

  • First, to profit from rises in dollar interest rates, you might consider the Rydex Juno Fund (RYJCX), the price of which is inversely linked to T-bond prices (the fund shorts Treasury bond futures).
  • Second, you should consider investing in countries that have few domestic energy and commodity resources, and that have been particularly hard hit by the price spikes as a result. Those would include Japan and Korea, both highly productive economies that are forced to rely on imports for most of their raw materials. In Japan, the iShares MSCI Japan Index ETF (EWJ) is currently trading at 16 times earnings, and features a yield of 1.6%, giving it a good market spread.  In Korea, the iShares MSCI South Korea Index Fund ETF (EWY) trades at a lower Price/Earnings ratio of 12, though with a beefier yield of 1.9%

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