Hidden Inflation: Rising Prices Are Hitting Consumers Harder Than the Fed Will Admit

[Editor's Note: This look at "hidden inflation" is the first in a series of articles examining a rise in prices and what U.S. consumers have in store. Commodities are soaring, oil prices are surging to triple digits and rental costs are climbing. Look out for more articles on hidden inflation that will detail the rising costs of food, energy and housing, and strategies investors can use to safeguard themselves.]

Any U.S. consumer that goes to the grocery store or the gas station on a regular basis knows that prices are rising.

Unfortunately, those rising prices are set to soar even higher - and their effects on consumers will continue to be ignored by the U.S. Federal Reserve.

The United States has had a break from inflation the past couple years, while it exported higher prices to emerging market economies. The Fed's easy money policies created excess money that flowed overseas, and now those countries are seeing prices rise to threatening levels.

Recent reports indicate U.S. inflation is also headed for an upswing. Money growth in the United States is up to worrying levels, oil prices have risen over $100 a barrel and continue to climb, and commodities prices continue to surge.

"[H]owever successful the Fed has been in exporting inflation since 2008, its success won't last for much longer," Money Morning Contributing Editor Martin Hutchinson said earlier this year. "At some point in 2011, inflation will be re-imported - and probably with a roar rather than a whisper."

The consumer price index (CPI) for January released by the U.S. Bureau of Labor Statistics (BLS) showed prices for all items except food and energy, also known as core inflation, were up 1% in January from a year prior.

But what core inflation isn't showing are the dangerous effects of hidden inflation, inflation that has not yet seeped into the core numbers - and could potentially drag down an already tepid economic recovery.

Hidden Inflation: What the Core Misses

Hidden inflation is digging into wallets and savings accounts, in the form of rising food costs and energy prices.

U.S. policymakers omit food and fuel costs from their core inflation calculation because they believe the two prices are subject to volatility and that core inflation is more indicative of underlying inflation trends.

But prices in these sectors are soaring higher.

The total price index including food and fuel - also known as headline inflation - was up 1.6% in January from a year earlier.

Price increases of energy and food accounted for two-thirds of the overall index jump. The food index has risen 1.8% over the last 12 months, the energy index is up 7.3% and the gasoline index is up 13.4%.

Recent research from Credit Suisse Group AG (NYSE ADR: CS) indicated "the common global concern of the moment is commodity price inflation."

And U.S. consumers are feeling the effects of these rising costs, despite the Fed's lack of attention to them.

More than 12% of after-tax income in U.S. households is now being spent on fuel and food, according to a CNBC report.

Even if prices have changed little for some items, consumers are getting less for their money than in years past, because they're paying the same price for a smaller rolls of toilet paper or fewer crackers in a package.

An example of official inflation numbers ignoring the effects of food prices is The Economist's Big Mac Index. It compares the global prices of one of McDonald's Corp.'s (NYSE: MCD) signature sandwiches to a country's reported inflation. The fast food chain's menu items rise in price along with food, rent, wages and materials, as restaurants pass along costs to customers.

The results showed Big Mac prices rose more than the reported inflation in many countries over the past 10 years. Argentina's burger inflation was up 19%, while its official inflation rate was only 10%. China burger prices were up 3.7% against the 10-year inflation rate of 2.3%, for a difference of 1.4%, about the same in the U.S. burger-to-inflation comparison.

Higher priced commodities are already pushing up the prices of many retail food items. The consumer price index for food at home posted its largest increase in two years in January by rising 0.7%, with all six major grocery store food group indexes rising.

The rising costs of commodities are creating a ripple effect through the food industry. In one of the most dramatic price surges, corn hit a 30-month high in January. Because corn is used as livestock feed, its price climb has pushed up the price of many meats.

Pork is up 12% from a year ago, beef is up 6% and poultry 2%, according to Michael Swanson, an agricultural economist at Wells Fargo & Co. (NYSE: WFC).

"Either the hog guy is going to go out of business or you're going to pay more for pork," Swanson told The Wall Street Journal. So if you "want barbecue ribs, you're going to have an extra $10 attached to it."

Cereal prices are inching higher due to wheat costs, and packaged and canned coffee is climbing since coffee bean prices jumped 77% last year.

Commodity prices are affecting more than just food. Cotton futures surged 92% in 2010, due to growing demand and supply constraints from floods in Pakistan and heavy rains in China. Higher cotton prices hurt consumers who buy clothing, sheets and towels. Retail prices of jeans are expected to rise 4.3% this year, sweatshirts/sweatpants 2.4% and T-shirts 1.8%, according to Cotton Inc.

Inflation has also hit housing budgets. Real estate development executives are predicting double-digit rent increases in the years ahead due to an increasing population of renters and a limited supply of housing units.

U.S. factory operators also have felt the price pinch. Raw materials costs in January reached their highest level since July 2008.

Even if rising prices haven't yet affected core inflation statistics, they are hurting consumers by making it more difficult to buy apparel, housing and transportation. With gasoline prices expected to approach - if not top - $4.00 a gallon this year, there won't be much money left in household budgets to maintain spending levels needed to drive the U.S. economic recovery.

Consumers Lose Purchasing Power

Some consumers facing higher prices at stores are also dealing with less income.

Those relying on Social Security benefits haven't seen a cost of living adjustment (COLA) in two years. The COLA is based on increases in the CPI for urban wage earners (CPI-W) from the third quarter of the prior year to the third quarter of the current year.

In 2009, Social Security beneficiaries received a 5.8% increase because of a spike in energy prices in 2008's third quarter. The next year there was no COLA because the CPI-W decreased from the third quarter 2008 to the third quarter 2009.

Last year, however, prices were up 1.5% in the comparable time periods. But the COLA remained zero for the nearly 58 million people receiving benefits because prices did not rise as high as they did in 2008.

As consumer prices keep climbing, Social Security beneficiaries are taking in the same amount of money - and household budgets are continually strained.

The Congressional Budget Office is projecting a small 0.4% increase in 2012.

Advocates for citizens relying on Social Security benefits claim the CPI-W doesn't adequately take into account the most costly expenses for older Americans, like medical care and housing.

"The existing COLA formula does not account for the economic reality of the true costs that most seniors faced," Fernando Torres-Gil, director of the University of California, Los Angeles Center for Policy Research on Aging, told the Associated Press.

U.S. Policies Will Fuel Fire

U.S. policy makers continue to downplay concerns about rising prices.

U.S. Federal Reserve Chairman Ben S. Bernanke told the Senate Banking Committee last week that climbing commodity prices would likely affect consumers, but that effect will be "temporary and relatively modest."

"My sense is that the increases we've seen so far -- while tough for many people -- do not yet pose a significant risk to the overall recovery," said Bernanke.

The Fed continues to maintain policies that encourage economic growth by keeping interest rates near zero and buying Treasury bonds. But critics of these policies say the central bank's short-term focus is dangerously blind to future inflationary dangers.

"My concern is that the cost of the Fed's current monetary policy - the money creation and massive balance-sheet expansion - will come to outweigh the perceived short-term benefits," said House Budget Committee Chairman Rep. Paul Ryan, R-WI.

Foreign leaders have voiced increasing concerns over global inflation and have asked the Fed to look beyond the core numbers.

European Central Bank President Jean-Claude Trichet said last week that the ECB is looking to raise interest rates next month for the first time in almost three years to combat rising inflation.

"Strong vigilance is warranted," said Trichet.

Trichet has warned before that core inflation isn't always the best indicator of future rising prices.

"In the U.S., the Fed considers that core inflation is a good predictor for future headline inflation," Trichet said in an interview with The Journal. But elsewhere around the world, "core inflation is not necessarily a good predictor."

Some U.S. policymakers are starting to admit the Fed's policies might soon warrant adjustment to curb climbing prices. Richmond Federal Reserve Bank President Jeffrey Lacker said businesses are starting to complain of rising costs squeezing profit margins.

"They're not able to pass on those cost increases [to consumers] now but they expect to be able to, some of them, in the later part of this year," said Lacker. "If that were to happen that could push the inflation rate up over a broad range of prices and that would be a very worrying concern for a central banker."

Inflation fears are already spreading from consumers to the markets. U.S. Treasuries have been falling and yields pushed higher on inflation concerns. Fixed-income investments like Treasuries lose value with inflation and worried investors are retreating from the once safe-haven bonds.

Bill Gross, manager of the world's biggest bond fund at Pacific Investment Management Co. (PIMCO), said in a Bloomberg radio interview last week that headline inflation gains are more worrisome than Bernanke suggests. Gross said rising oil prices could trim U.S. gross domestic product (GDP) growth by a quarter to half a percentage point.

"Bernanke tends to think this doesn't matter - at least in terms of headline versus the core - we do," said Gross.

Even a small rise in prices could hurt the two-year bull market as consumers lose confidence when faced with inflation on top off a bucket of other concerns, like poor state and local governments, reduced spending by the federal government and possible tax cut expirations in years to come.

Concerns will only worsen if the U.S. central bank continues to ignore the warnings. Money Morning's Hutchinson said this current bout of inflation will be around for a while, much like in the 1970s when rising prices and high unemployment combined to form a period of stagflation.

"[W]e can expect inflation to be with us for several years this time, too," said Hutchinson. "In fact, expect it to get worse for the next three to four years, while Ben S. Bernanke remains at the helm of the nation's central bank."

[Editor's Note: If investors have to now worry about the "I-word" - inflation - they're also going to have to worry about the "R-word" - retirement.

Here's the problem: The longer you work, the more you can save - and the longer the rampant inflation we're expecting will have to work on your nest egg.

But here's the solution: Boost your rates of return.

That's actually just as easy as it sounds. You just have to have the right strategy - and the right investments. And as a subscriber to The Money Map Report, our monthly affiliate, you can count on getting both. Find out by clicking here to read a report that details this strategy.]

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