Brace Yourself: Inflation Is Coming This Way

The Federal Reserve has poured $2 trillion into the economy over the past three years, resulting in the greatest year-over-year increase in our money supply on record. But if the Consumer Price Index is correct, this hasn't ignited a period of high inflation, as consumer prices in September increased by only 3.9% over last year. Does this mean inflation is dead? Hardly. As we'll soon find out, it's both alive and headed this way.

Rising prices on the horizon
The mechanics of inflation are best understood if you think of money as a commodity. The price or value of a commodity is a function of supply and demand. As you know from economics 101, if supply increases relative to demand, the price or value of the underlying commodity will decrease, and vice versa.

These straightforward rules apply to money. Namely, when a central bank increases the money supply by purchasing securities on the open market, its value should theoretically decrease. And when a central bank decreases the money supply by selling securities on the open market, its value should increase.

As a result, it initially seems odd that the most recent Consumer Price Index increased by only 3.9% at the same time as the money supply (M1) increased by more than 20%. Given the relationship between money supply and prices, shouldn't the magnitude of these increases be roughly proportional? Well, maybe. But that's beside the point. For as we'll see, higher inflation is here, it just hasn't hit the consumer yet.

A glance up the supply chain reveals both the source and progression of higher prices toward the consumer.

On the ground level, the prices of corn, oil, and gold are up by 50%, 107%, and 37%, respectively. Move down the chain, and you see that the Producer Price Index (basically the Consumer Price Index for manufacturing and production companies) decreases as it approaches the consumer -- going from 8.3% at the intermediate production stage, down to 3.9% at the consumer stage. Over time, however, this relationship is bound to even out, as producers move to share more of the burden with consumers.

Inflation-proof your portfolio
If it's true that higher inflation is on the way, and I think it is, then it's important to allocate your assets accordingly, as cash will only deteriorate over time. The big question, of course, is how to do so.

The traditional way to shield a portfolio from inflation is to anchor it in tangible assets. You could do this through an exchange-traded fund like the SPDR Gold Trust (NYSE: GLD), which gives you direct exposure to gold. Or you could do this by investing in companies that produce tangible assets, like Molycorp (NYSE: MCP) -- a rare-earth producer of oxides, metals, alloys, and magnets, among other things -- or Paramount Gold and Silver (NYSE: PZG) -- an exploration-stage mining company in Mexico.

The danger in the traditional approach is that the prices of commodities like gold have already skyrocketed and may even be approaching bubble-territory.

The method I prefer is investing in companies with pricing power, ones that can pass price increases on to their customers without significantly impairing the bottom line. The poster child of pricing power is Coca-Cola (NYSE: KO), which regularly records gross margins of 60% or higher due to the power of its brand. Two less attractive but equally compelling examples are Philip Morris International (NYSE: PM) and Altria (NYSE: MO), whose products are addictive regardless of price. While it may not be as true with respect to Philip Morris and Altria, owning a company like Coca-Cola makes it much easier to sleep at night regardless of what the economy is doing.

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