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.
September Consumer Price Index
October Producer Price Index: Finished Goods
October Producer Price Index: Intermediate Goods
Increase in Commodity Prices Since 2008 (corn/gold/oil)
|3.9%||5.9%||8.3%||50% / 107% / 37%|
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
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
As a final note, our in-house analysts here at The Motley Fool drafted a free report that details three under-the-radar companies that will profit from an increase in the price of oil, one of the main causes of economywide inflation. Click here now to get the free report.
Fool contributor John Maxfield, J.D., does not have a financial stake in any of the companies mentioned in this article. The Motley Fool owns shares of Philip Morris International, Coca-Cola, and Altria Group. Motley Fool newsletter services have recommended buying shares of Coca-Cola and Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.