Wednesday, February 27, 2008

More Inflation

David Ranson of H.C. Wainwright & Co. Economics has an editorial in the WSJ today about commodities as a leading indicator of inflation:

The most timely figures come from the commodity markets, where prices are transparent and reflect conditions in the immediate present. Yet commentators tend to discount volatile data like energy and food prices when they assess the "underlying" rate of inflation. This is a big mistake.

Obviously, with commodity markets booming, that is not good news. Ranson provides a simple rule of thumb to estimate inflation:

There is a remarkable parallel between annual CPI inflation and the cumulative change in the price of gold measured from eight years before. A similar graph could be plotted for silver, and the parallel can also be seen in cross-section by comparing countries over time with varying degrees of currency instability.

Historical CPI data in the U.S. are complicated by occasional changes in the methodology the government uses to calculate the index. In the late 1990s, one of these changes reduced the reported inflation rate significantly. But taken as a whole, the relationship suggests my following rule of thumb to estimate CPI inflation at any time: Divide the percentage change in the gold price from eight years in the past by 80, and add three. This rule of thumb has largely worked over the past several decades. In the last eight years the price of gold has risen 225%. The rule therefore comes out with an answer that puts inflation a lot closer to 6% than 4%.

Thank goodness we include commodities in all our portfolios. It's the only way I know to protect yourself from inflation. Most advisors tell their clients that stocks are the only way to beat inflation over the long run. That is true over the very long term but the only way to protect yourself in real time is to own commodities.

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