Don't Let Inflation Burn You

There's a much bigger threat looming than the housing crisis and possible recession that get all the attention. Unfortunately, economic and political leaders ignore the threat, and the only people who seem to be worried about it are ordinary folks on Main Street.

Inflation is back with a vengeance. Oil prices have topped $100 per barrel, and gas prices look poised to climb back above $4 this summer. Everyday expenses from food to health insurance are jumping through the roof, straining people's already tight budgets. Prices at the consumer level rose 4.3% over the past year, and costs earlier in the supply chain are rising at a much faster pace.

Producer prices and you
The release of the producer price index earlier this week brought unexpectedly bad news. Prices of finished goods rose a full percentage point in January, bringing their 12-month change to 7.4%. That's the biggest yearly rise since 1981, during the aftermath of the inflationary spike that followed the oil price shocks of the 1970s.

More alarming is the fact that prices for products earlier in the production chain rose even more steeply. Costs of intermediate goods rose 8.8% in the past year, while crude goods were up a staggering 31% from last year's levels.

Yet many economists remain unconcerned about inflation. One reason is that core inflation -- which excludes the volatile food and energy portions of the index -- remains relatively low. Another is that a different set of inflation data -- the price index calculated with GDP estimates -- suggests a lower inflation rate of 2.7% in 2007.

A no-win scenario
During his testimony before Congress, Fed Chairman Ben Bernanke argued that inflation is likely to moderate over the next year, with the expectation that energy prices will stabilize.

Rising costs at the producer level put investors in an unenviable dilemma. If companies are able to pass higher costs on to consumers, then costs of living will continue to rise at an accelerating rate. On the other hand, if businesses can't raise their prices to recoup higher costs, then profits will fall, hurting stock prices and causing investors to lose money.

Already, the battle lines are being drawn. Airlines are looking for ways to cover higher fuel costs, with UAL's (Nasdaq: UAUA) United charging $25 for two checked bags. But attempts by AMR's (NYSE: AMR) American Airlines and by Northwest Airlines to double fuel surcharges quickly failed.

Similar actions throughout the business world have investors concerned. From higher costs on coffee prompting Starbucks (Nasdaq: SBUX) to raise prices last summer, to rising dairy and grain costs impacting food producers like Kraft Foods (NYSE: KFT) and Tyson Foods  (NYSE: TSN), profits are feeling the heat. Yet if businesses succeed in getting consumers to pay more, inflation at the consumer level will flare up -- potentially creating a much bigger problem for the economy as a whole.

What to do
From an investment standpoint, higher costs have created large windfalls for some industries. For instance, companies that serve the agricultural sector, such as Monsanto (NYSE: MON), have benefited greatly from higher crop prices. Similarly, mining companies of both precious and base metals have seen strength in stock prices: BHP Billiton (NYSE: BHP), for example, is up nearly 40% from its January lows.

Identifying industries that will benefit from higher costs for base materials is essential to protect your portfolio. Without that protection, if businesses end up having to absorb higher production costs, then ailing corporate profits will likely show up in lower brokerage account balances for investors. Yet as bad as falling stock prices would be, they might turn out to be less painful for the overall economy than if inflation heats up further on the consumer level.

For more about the challenges facing the economy, read about:

• How Ben Bernanke is making things worse.
• Why housing prices may be close to bottoming out.
• Which big broker thinks a recession is around the corner.