Ben Bernanke is bugging me. His Federal Reserve is completely ignoring one of its mandates in a futile attempt to dodge the consequences of years of loose lending and lackadaisical regulation.
The Federal Reserve has three objectives: maximum employment, stable prices, and moderate long-term interest rates. At this point, they seem far more focused on saving banks and hedge funds from their own ludicrous mistakes (perhaps under the guise of pursuing maximum employment) than on ensuring that prices don't go through the roof.
Pit or pendulum?
Let's look at the stats. From 1991 to 2006, annual inflation -- as measured by the consumer price index -- averaged 2.6%. The highest annual inflation during those 16 years was 3.4% in 2000, at the peak of one of the longest expansions in history.
That all changed last year, when we hit a 4.1% inflation rate. And the trend is worsening. The 12 months ended in January had a 4.3% rate, and month-over-month inflation was about 6.1% annualized. The Fed's response? Totally ignore skyrocketing prices. Stimulate the economy by cutting interest rates.
True, there is a housing bust and debt crisis going on right now. I know that, and so does Bernanke. People who bought houses that they couldn't afford are struggling. Lenders who gave them money are finding it tough, too. Some might say that their suffering will encourage both of these parties to stop doing stupid things. Instead, the Fed is desperately trying to solve their short-term problems, regardless of the long-term consequences to the rest of the country.
Politically, it makes sense. The average person probably doesn't understand the evils of inflation, except when he or she is temporarily outraged at the price of gas. And at times like these, inflation can disguise many of the market's ills. If you have high inflation, then while home prices might fall a massive amount in real terms, they won't fall nearly as much in nominal terms.
The big losers
The problem is that it will be hard to stimulate the economy with low rates while inflation is spiking. In fact, inflation fears could actually cause long-term lending rates to increase. After all, would you lend money for the long term at a rate lower than inflation? Every year, in real terms, you'd be losing ground on that investment. As a result, businesses that rely on borrowing to fund their growth may find it harder to raise capital even though the Fed is cutting interest rates.
What's more, the people who will be hurt by these pro-inflation policies won't be the speculators who pushed up home prices to unsustainable levels or the banks that enabled them. Instead, prudent Americans will suffer. Retirees who worked for a lifetime, for example, will see the purchasing power of their nest eggs shrink as prices rise.
Now, the high inflation scenario isn't a certainty. Maybe the economy is slowing enough that inflation will fall. Maybe, despite spiking commodity prices, we've actually seen the peak in inflation. I sure hope so.
But if you're an investor, you should have a plan for living in a world of higher inflation. In that world, long-term bonds at today's yields will probably be dreadful investments, potentially offering negative real returns.
Instead, focus on stocks. Look for companies that don't need to buy increasingly expensive commodities to manufacture their products. Buy high quality businesses with solid competitive positions that can increase prices as costs increase.
General Motors (NYSE: GM ) , with exposure to steel and fierce competition from Toyota (NYSE: TM ) and other foreign manufacturers, will probably have a hard time. But oil should be a natural hedge against inflation, so ExxonMobil (NYSE: XOM ) should be fine.
Pharmaceuticals such as Pfizer (NYSE: PFE ) and Merck (NYSE: MRK ) should also do well, since their patents will protect them from competition and consumers will pay what they need to for health care. Similarly, companies with strong consumer brands, such as PepsiCo (NYSE: PEP ) and Procter & Gamble (NYSE: PG ) should have enough pricing power to raise prices to match inflation. People will eat, drink, and brush their teeth, even in inflationary times.
The Foolish bottom line
If you buy these kinds of companies cheaply, then you'll win either way. Should inflation continue to increase, you'll be covered. If it doesn't, then you'll still own a great company at an excellent price -- a combination that should result in extraordinary returns.
Many of our Inside Value recommendations are tailor-made for this sort of strategy. So if you're looking for stocks that can both support your portfolio in an inflationary environment and provide the huge returns that you can get from undervalued stocks, I invite you to try a 30-day free trial to Inside Value.
Fool contributor Richard Gibbons is at least twice as incensed about Greenspan as he is about Bernanke. Richard does not have a position in any of the stocks in this article. Pfizer is an Inside Value pick and an Income Investor pick. The Fool disclosure policy makes great bedtime reading!