– T. Boone Pickens

Inflation can do tricky things to markets. It creates distortions. In those distortions, an intrepid investor can find some big moneymaking ideas. I think we’ve got one opening up in oil and gas, and it is not without precedent in financial markets. In fact, it’s starting to look a little like the tail end of the 1970s in some respects.

In the spring of 1969, the Dow Jones industrial average stood at 969. By 1982, the Dow hit 1,071. That’s thirteen years of going nowhere. (We’ve had 10 years or so of going nowhere, though the ride between the poles has been anything but boring).

The problem is inflation makes that performance look better than it really was, like when a crooked judge makes a fight look close with a split decision even when the one fighter can barely walk to his corner and everybody in the building knows it was a rout.

Adjusted for inflation, or the weak dollar, the Dow was really more like 400. That makes it one of the worst stretches for the market since the 1930s.

The consumer price index, that flawed measure of inflation, doubled from 1960 to 1982. This is why a generation of people grew to believe that the best way to buy a house was to borrow all you could afford. And for a time, that looked brilliant. As Robert Sobel relates in a history of the period, a modest suburban home going for $30,000 in 1969 sold for $300,000 13 years later. With a lot of debt, your returns were much greater.

Of course, that kind of thinking eventually got us into a heap of trouble, as we now know.

But that period of time also had an effect on Corporate America’s balance sheets. When a company buys an asset, say a factory, it records its cost on its books. It will then depreciate this asset over time. So the value of the factory on its books will decline over time.

In a period of high inflation, its book value will be understated. The cost of a similar factory will be a lot higher in dollar terms, though the company will still show the old figure.

In other words, during periods of inflation, book values understate the true value of corporate assets. This happened in the 1960-82 period. Combine that phenomenon with a stagnant stock market and, eventually, you get some very cheap stocks. This is exactly what happened during the inflationary 1970s. Thus, by the early 1980s, stocks were quite cheap indeed.

In fact, by July 1984, S&P reported that 30% of the stocks on the NYSE traded below net tangible book value. The old value mavens like Ben Graham would have had a field day.

What happened next, though, is what interests us especially. The low stock prices kicked off a takeover boom. The 1980s takeover mania was the busiest since the “age of Morgan at the turn of the century,” Sobel reports in his The Age of Giant Corporations. The 1980s was the age of the LBO, Barbarians at the Gate, Michael Milken and the corporate raider.

The oil industry also had its takeover boom. In fact, the outlines of the 1980s oil and gas industry look similar to today’s. In 1970s, there was a drilling boom as people thought that oil and gas prices would rise indefinitely. That collapsed and then you had oil and gas companies sitting on huge reserves they built up during the boom.

So in a time when it cost $15 a barrel to get oil out the ground, many oil companies traded for $5 a barrel in proven reserves. Getty Oil traded for $72 per share, with assets of $250 per share. Marathon’s stock went for $68, even though each share had $210 in assets backing it up. And on and on it went.

Enter T. Boone Pickens. An Oklahoma-born geologist, Pickens was well aware of the value of these companies. He started going after them and making millions of dollars as bidding wars ensued. He lost several of these, but still cleared millions in profits.

There was a roll call of takeovers in the industry during this time — Shell bought Belridge Oil for $3.6 billion, DuPont bought Conoco for $7.4 billion and U.S. Steel took out Marathon for $6.5 billion. (Yes, U.S. Steel thought it would be smart to diversify). These were some of the bigger deals.

I won’t go too much into the history of this period, and perhaps I’ve already gone into too much detail. But I think something similar may be unfolding in today’s market.

In oil and gas, we have many companies trading cheaply in the wake of a drilling boom gone bust. What we need now is a T. Boone Pickens to shake things up.

When I look at some of my favorite oil and gas stocks, like Contango Oil & Gas (MCF:amex), I see stocks trading for far less than what it would cost you to find those reserves. If I were a natural gas producer, I’d look to pick up stocks like these, rather than drill new wells. At some point, I think that will happen and we’ll see lots of buyouts in the oil and gas sector.

Natural gas is very cheap right now, but it won’t always be the case. In a new research report by Tudor Pickering Holt & Co., a very good firm specializing in energy, $7.50 natural gas prices is forecast for next year! That’s pretty bold considering natural gas is under $3.00.

The firm bases this prediction on a comprehensive, bottoms-up model that takes into account rig count, decline rates on existing wells and other variables. According to Tudor Pickering, “The die is cast for 2010” — there is no way to get around a dramatic decline in natural gas production next year. And even assuming tepid demand for natural gas, we’re going to have a very different picture in natural gas next year.

After that, Tudor Pickering predicts the market will get full again by 2011. If it is right, we have a great window to make money between now and probably the middle of 2010 in natural gas.

Source: The Coming Takeover Boom

Take the Consumer Price Index, a widely used measure of inflation. It tracks inflation in part by comparing a basket of commonly consumed goods over the years.

Governments don’t like inflation. So they simply pull a fast one on Joe Public and swap the goods in the basket as it suits them. This from TradeSystemGuru.com’s Matt Blackman:

In an effort to keep inflation down and accentuate growth, statisticians shamelessly distort and manipulate the data. For example, the Consumer Price Index measures inflation in part by comparing a basket of goods over the years. But what is not publicly understood is that each year, that basket changes. […]Here is just one example of how one of these tools, namely substitution, works. If the price of salmon goes up too much, the Bureau of Labor Statistics substitutes it for a cheaper food item like say hot dogs. The result is that from 2007 to 2008, CPI showed a 4.1% rise in the price of food. But according to the Farm Bureau, that tracks the same basket (without using substitution, weighting or hedonics), food prices actually rose 11.3%!

Employment figures are also fudged. As James Dale Davidson points out in the upcoming issue of Crisis Strategy Alert:

The official unemployment statistic picked up in today’s headlines, the Bureau of Labor Statistics’ U-3 measure, does not count everyone who is unemployed and underemployed.But that’s not the only problem with the numbers.

The government also inserts an official fudge factor – which in May amounted to 220,000 fictitious jobs. These so-called “birth/death” statistical adjustments arbitrarily add fluctuating numbers of jobs to the total measured employment. This supposedly accounts for jobs supposedly being created by new businesses that are supposedly too small and young for the government to detect. U-3 is also flawed in that it doesn’t count people ineligible for unemployment benefits. […]

To get a real picture of the current unemployment levels you need to focus on the grossly underreported U-6 data set known as “alternative measures of labor utilization.” The U-6 data set includes everyone counted in U-3, plus “all marginally attached workers” and people who aren’t working full-time but wish they were (i.e., the underemployed). (Marginally employed covers “persons who currently are neither working nor looking for work but indicate that they want and are available for a job and have looked for work sometime in the recent past.”)

When you add up U-3 and all the underutilized workers, the official U-6 rate for May 2009 is 16.4%. In other words, the employment picture is twice as bad 14 months after the recent peak as it was in December 1930, 18 months after the peak prior to the Great Depression.

As James says, “If you take care to analyze the data, it’s easy to see that there are not many green shoots growing. In fact, when you put aside the hype and look more carefully, indicators such as employment, industrial production, stock prices and international trade are all tracking their trajectories from the Great Depression… or worse.”

Taking care to analyze the data can clearly mean the difference between a good investment decision and a bad one… the difference between a stock market victim and a successful investor… the difference between a comfortable retirement and a last-minute scramble to cover a pension shortfall.

If you’re interested in discovering the truth behind the government’s lies about the economy and protecting your wealth during the current crisis, you can take a 60-day risk-free test drive of James’s research service.

You will get immediate access to past issues, weekly updates on how to profit in the downturn and the full Crisis Strategy Alert portfolio. If you decide within the first two months of the test drive that James’s investment research and crisis recommendations are not for you, it won’t cost you a dime… guaranteed. Frankly, this is a no-lose offer. Take it or leave it. It’s entirely up to you.

One thing the feds can’t fudge is the amount of tax receipts they take in. As Barron’s recently put it, “nobody pays taxes on phony, phantom jobs or earnings.”

According to Trim Tabs, the decrease in income-tax withholdings since May “indicates wage declines and job losses have accelerated.” This from Barron’s:

[I]ncome-tax withholdings in the past four weeks are down 6.1% from a year ago; in the last two weeks, they’re down an even bigger 8.1% from last year. That marks a sharp deterioration from May, when income-tax withholdings were off “only” 4.8% from a year ago. […]Meanwhile, “other” taxes were down 39.5% year-on-year, down from 33.6% in May. Corporate income taxes were down 35% from a year ago in the latest four weeks after having been down 12.3% year-on-year in May. […]

Not only do plunging tax revenues tighten the fiscal vise on the federal, state and municipal coffers, they provide unambiguous confirmation of the truly dire straits of the economy.

These numbers, of course, are at odds with the surge in the stock market, which had lifted the averages by about a third from those March lows. Now, however, equities appear to be rolling over, which could be nothing more than profit-taking to nail down wins ahead of the end of the second quarter.

But the advance also seems to be losing steam in bourses abroad as well as in commodities, which suggests much of the surge was liquidity-driven, not unlike last summer’s spike in crude oil prices to $147 a barrel. We’ll see.

Last week Drew/Jack used the phrase “financial obesity”.  Now of course this was viewed in a humorous manner, but it sent me down a different path.

The term financial obesity may sound like fun, if you are the one fat with cash.  But I kept thinking about obesity in another form.  The obese budget deficit we are looking at in this country is extremely daunting.  Democrats can blame the Bush administration for the deficit that President Obama inherited and Republicans can blame the various stimulus packages of the Obama administration, but pointing fingers isn’t going to solve the problem.

When I was thinking about this article I shared my thoughts with my colleagues and I pointed out how if a person is overweight, they didn’t gain 100 pounds overnight and they aren’t going to shed the extra weight overnight either.  My colleague Jon Herring pointed out that you aren’t going to lose the extra weight by eating more ice cream either.

Not only are we eating more ice cream, we are eating the cake as well and then we are washing it down with chocolate milk.

I could care less who you want to blame when it comes to the budget.  The only two things I want to know are how are we going to fix it and how can I profit from it?

As for now, inflation is being kept in check.  But you can guarantee that inflation will rear its ugly head at some point in the future.  There is simply too much money being printed and eventually all those dollars floating around in the economy will be chasing a supply of goods that simply isn’t large enough.

So how do you invest for inflation that isn’t here yet?

First, you want to wait until you see the Consumer Price Index and the Producer Price Index creeping up a little bit.  Don’t wait until it is a concern and then react, when it starts increasing slightly you want to take action.

The actions you will want to take are as follows: diversify your portfolio with appropriate allocations to bonds, precious metals and stocks.  How much do you allocate to each?  That is really up to you, but you will want to factor in things like your age, your comfort level with risk and how many years you have until you retire.  There are other factors, but my point is you want to diversify with a balance of investment vehicles, not just diversify within the stock market or bond market, you have to diversify among asset classes as well.

And if you think you can diversify with foreign investments, you are only partially right.  I was reading some data from Dimensional Fund Advisers, a mutual fund company that applies extreme levels of academics to their investing practices, Thursday evening.  Included in that material was a table showing the performance of various global equity markets over the last 24 years.  There were two things that jumped out at me from that table.  First, the only equity market that was positive in the bear market of 2001 was the Australian market (+1.68%).  This list doesn’t include all equity markets, but it includes all the countries I would consider developed markets.  The second thing that jumped out at me was the fact that over the last 24 years, the U.S. equity market has never been the top performing market.  Among the other markets that have not been the leading market over the last 24 years are France and Germany.

These two pieces of information tell me two things: one, diversification among different countries only gets you so far and secondly, the thought of seeking safety in the most developed markets leads to underperformance in most instances.  This should all tie back in to your comfort level.

As far as my plan, I will probably leave approximately 50% of my portfolio in equities (diversified among various markets and sectors of course), and then put approximately 25% each in bonds and precious metals.  And when I talk about my portfolio, I am talking about the 80% I view as long-term.  The 20% that I trade on a short-term basis changes from day to day.

Make a plan for when the U.S. is forced to go on a diet, and don’t expect to shed these extra pounds in a few weeks.  It is going to take time to shed the extra weight we have put on in the last nine years or so.

Source: Financial Obesity

• UBS AG (UBS) said it will cut 11% of its staff and warned that the bank faces an uncertain future. In its first quarter earnings report, Switzerland’s largest bank posted a $1.7 billion loss. At its annual shareholder meeting, Chief Executive Oswald Gruebel told investors: “Unfortunately I am not able – as yet – to offer you any good news. Instead I am forced to present you with another round of unsatisfactory performance figures and to announce further drastic measures,” Reuters reported.
• India’s second-largest computer services provider, Infosys Technologies Ltd. (ADR: INFY), forecast its first annual drop in dollar sales, Bloomberg reported. For the fiscal year ended March 31, revenue will fall 3.1% to 6.7% to range between $4.35 billion and $4.52 billion.
• Foreign direct investment in China fell for the sixth consecutive month in March, as overseas companies and governments continued to curtail spending in the global financial crisis. Investment fell 9.5% to $8.4 billion compared to a year ago. Foreign investment declined 15.8% in February, Bloomberg reported.
• The consumer price index posted its first annual decline since 1955 in March, and idle American manufacturing capacity reached a record, alleviating concern that U.S. Federal Reserve actions would cause inflation to soar. Consumer prices fell 0.4% in March from 2008, the Labor Department said in Washington. Output at factories, mines and utilities in use slid to 69.3%. The figures signal deflation remains the bigger danger, and underscores Federal Reserve Chairman Ben S. Bernanke’s call for inflation to remain “quite low for some time.”
• Sentiment among U.S. homebuilders rose in April to its highest level since last October, the National Association of Home Builders said yesterday (Wednesday). The NAHB/Wells Fargo Housing Market index rose to 14 from 9 in March, emerging from single-digit territory for the first time in six months. April’s increase was the largest one-month gain since May 2003, Reuters reported.
• Bank of America Corp. (BAC), is boosting fees on transfers of card balances amid growing criticism of banking practices. The fees on sums transferred will rise to 4% from 3% on June 1, according to a notice mailed to customers. The change reflects increasing costs for the third-biggest U.S. credit-card lender bank, spokeswoman Betty Reiss said in an interview, with Bloomberg.
• Cisco Systems Inc. (CSCO) won U.S. antitrust approval for its purchase of FlipVideo digital camcorder maker Pure Digital Technologies, the Federal Trade Commission said yesterday (Wednesday).  The $590 million all-stock purchase is part of Cisco’s move into the consumer market, as its traditional routers and switches business slows down, according to Reuters.
• Brazil’s local bond yields hit an 18-month low on rising prices, as investors forecast the central bank will use interest-rate cuts to help boost growth in Latin America’s largest economy. Analysts forecast the central bank will cut interest rates on April 29 to avoid a contraction of gross domestic product this year.  Brazil’s Finance Minister Guido Mantega said yesterday (Wednesday) the government will keep adopting measures to spur investment and support an economic recovery.

Source: Global Investment News Briefs Thursday, April 16, 2009

Martin Hutchinson says the Fed has finally starting doing its job: putting price stability over Wall Street’s demands. Real interest rates are negative. This is feeding inflation. It also means Treasury bond yields – also currently below the rate of inflation – are too low and should begin to rise again.

Martin says investors can profit from this situation with the Rydex Juno Inverse Government Long Bond Strategy (MUTF:RYJUX).

More from Martin in Money Morning:

The statement that was issued after the policymaking meeting was somewhat “hawkish,” suggesting that the U.S. Federal Reserve is awakening to the dangers of persistent and gently rising inflation.

Wall Street was initially spooked: it had hoped for the usual bounce that follows a Fed rate cut. However, investors subsequently decided the Fed’s inaction meant things weren’t so bad after all. Actually, the inaction was the first example in several years of the Fed doing its job – standing up to the easy-money politicians and Wall Street in the pursuit of lower inflation.

The Consumer Price Index (CPI) for August registered a decline in prices of 0.1%, which observers hailed as an indication that inflation worries are at an end. But don’t you believe a word of it; the decline was entirely due to the recent fall in oil prices, which we here at Money Morning expect will one day reverse course and resume their upward march. The only question is when that will happen and what the catalyst will be to make it so.

In terms of the CPI, the “real” consumer price inflation was actually 5.4% over the past 12 months, which makes the 2.0% Federal Funds rate look pretty silly.

The same is true all over the world: Inflation rates are either well above the local bank base rates (2.3% vs. 0.5% in Japan, 12.1% vs. 9.0% in India), or are only just below them (3.8% vs. 4.25% in the Eurozone, 4.8% vs. 5.0% in Britain). Only China has inflation of 4.8% to go against a bank rate of 7.2% – just reduced from 7.47% – but China had been holding prices down with direct controls for the Summer Olympic Games, so its current inflation number is pretty dodgy.

If interest rates are at or below the inflation rate in most of the world, then it follows that global monetary policy is expansionary and inflation can be expected to increase generally.

You can’t entirely blame the world’s central banks; we have been in a credit crunch for more than a year now, and investment banks the size of Lehman Brothers (NYSE:LEH) and Merrill Lynch (NYSE:MER) getting in trouble is a pretty good indication that all is not well. However, there’s also no denying that low or negative real interest rates will tend to produce an acceleration of inflation.

The two objectives – saving the world banking system, and keeping inflation under control – are in conflict.

The market demonstrates the solution to the conflict.

On Monday the Federal Funds rate traded for much of the day at 6.0%, versus the Fed’s target of 2.0%. To get the market Federal Funds rate down towards the target, the Fed needed to inject lots of liquidity, which it did – to the tune of about $70 billion.

That liquidity increased the money supply, but only to make up for the decrease caused by bank failures and market fear, thus restoring the market’s balance and lowering the Federal Funds rate to about 3.0% by the end of the day’s trading. An interest rate cut Tuesday would simply have moved the “target” Federal Funds rate, rather than the actual rate, and would have led to more inflationary pressures without materially helping the banking system.

Indeed, one can wish that the Fed had confined itself to injecting liquidity throughout this prolonged credit crunch, keeping the Federal Funds rate level at its September 2007 level of 5.25%. In that case oil prices would probably never have soared to $147 a barrel, and U.S. inflation might have remained safely around 3.0%.

Going forward, it seems clear that next time the FOMC meets without having had about half of Wall Street disappear in the preceding week (the next scheduled meeting is Oct. 28-29), it will be tempted to announce a modest interest-rate rise, unless the U.S. economy is truly in the tank by then. Of course, the Fed would remain ready to lower rates again if a deep recession appeared, or to inject liquidity if more banks got in trouble.

That would suggest that the current sharp drop in yields on long Treasury bonds has been overdone (from 4.25% in June to 3.25% yesterday (Tuesday) morning, before rebounding to 3.49% at yesterday’s close). Thus, a rebound in Treasury bond yield – taking them significantly above the level of inflation – is called for as money is tightened and the Federal Funds rate rises.

To take advantage of such a yield rebound, you should consider the Rydex Juno Inverse Government Long Bond Strategy (MUTF:RYJUX). This invests in short futures contracts on long-term Treasuries. It can be expected to gain as Treasury yields rise.

Source: Federal Reserve Policymakers Stand Up to Wall Street’s Easy-Money Crowd

The US Labor Department said prices increased by 0.6% in May, a higher increase than forecast.

John Mauldin examines the causes of inflation in in Outside the Box…

President Nixon instated price controls on the 15^th of August, 1971. Inflation was a little over 4% at the time. Price controls manifestly did not work (resulting in shortages of all sorts and a deep recession) and were rescinded a few years later. President Ford went to Congress with programs to fight inflation that was running closer to 10% in October of 1974, with a speech entitled “Whip Inflation Now” (WIN). He famously urged Americans to wear “WIN” buttons. That policy too was less than effective, and the buttons, in a history replete with silly gestures by governments, should stand on anyone’s top ten list of such silly gestures.

Cynics more thoughtfully wore the buttons upside down and said the inverted letters (which looked like NIM) stood for “No Immediate Miracles.” They were right. There was no miracle, just eventual pain and lots of it. Ultimately, Paul Volker defeated inflation, but at the cost of two serious recessions and a lot of economic misery, with unemployment levels over 10% for nine months in 1983.

This week we were given the data that inflation as measured by the Consumer Price Index (CPI) over the last year was 4.2% and unemployment is now 5.5%. Some call for the Fed to raise rates so that we do not have to experience another lost decade like the ’70s and then ultimately see some future Volker forced to raise rates and drive unemployment back to 10%. Others suggest that “core” inflation is what should be paid heed to, and urge caution.

This week we look at the cost of what could be a renewed effort to Whip Inflation Now, not just here but in countries worldwide. Will Trichet in Europe raise rates even as the European economy seems to be slowing down? If you think inflation is bad in the US and Europe, take a peek at Asia. And I ask, “What will Ben do?” It should make for an interesting letter.

Whip Inflation Now

Nixon and his advisors thought inflation at 4% was serious enough to institute price controls. Headline inflation in the US is now 4.2%. What kind of economic policy should we pursue to bring inflation back into the Fed’s comfort zone of 1-2%? Would it work and would it be worth the pain? To get a handle on the question, let’s go to the data from the Bureau of Labor Statistics and see where inflation is coming from.

And let me note, this is the same exercise we could do for a host of countries. The answer will be roughly the same: there are no easy solutions.

Core inflation, or inflation without food and energy, grew at 2.3%. Inflation without food costs was an even 4% and without energy was 2.7%. Clearly energy was the leading contributor to inflation in the past year.

But the recent trend in rising inflation is even more worrying. If you look at just the last three months of data and compute an annualized rate of inflation, you find that overall inflation has risen to 4.9%, energy inflation is running at a staggering 28%, and food costs have risen 6.2%. Meanwhile, core inflation during that period dropped to 1.8%. You can see all the data at http://www.bls.gov/news.release/cpi.nr0.htm.

Now, gentle reader, let’s think about these numbers. Food (over 14%) and energy (over 9%) combined make up roughly 24% of the CPI, yet were responsible for over 60% of the recent three-month trend in inflation. By the way, housing was up 4.9% and transportation up 8.7%, so it was not just food and energy.

What would it take to drop headline inflation back to under 2%? Well, one way would be for food and energy prices to fall. Let’s look at the possibilities.

As Donald Coxe has noted, North America has had an 18-year run of remarkably good weather in our growing season. You have to go back 800 years to get a string of years that were that good. Yet today food reserves of all types are at decades-long lows. There is very little room for any type of problem.

This growing season is not off to a good start. It looks like the yield on the corn crop will be lower than normal, and that is if we get very benign weather this fall. Given how late much of the US corn crop was planted, and how torrential rains in the corn belt have devastated crops (not to mention flooding cities, and our thoughts and prayers go out to those who have lost their homes to flooding), an early frost would be disastrous.

Because we have devoted so much of our arable land to corn (in a very misguided policy to turn food into ethanol), we have less for soybeans, which is putting upward price pressure on beans and other grains that are used to feed cattle, hogs, chickens, etc. In fact, it costs so much to feed livestock that ranchers are shrinking their herds.. This means more meat is coming into the system now, which is dampening prices. Increased supply will reduce prices in the short term, but next fall we will find that supplies of all types of meat will be short. That will potentially send meat prices soaring. Cereal and bakery products are up 10% over the last year. They could continue to rise in the fall if the corn crop does not yield more than currently projected. It will cost even more to feed your household and feed the animals we need for meat.

Food is the most basic of commodities. Demand is fairly consistent, and supplies may come under pressure. Looking for food inflation to drop back by the fall to 2% is not realistic in the current environment.

What about energy? There is some more hope there, at least on the oil front. High prices have reduced demand in the US, with gasoline usage down about 4%.

I think we have reached a tipping point. The psyche of the US consumer has been permanently scarred. Slowly, this country is going to replace its fleet of cars with smaller, more fuel-efficient cars. Over time, we will see demand continue to fall. We could see further drops in the demand for gas in the next few months.

Much of Asia used to subsidize oil prices to their consumers. That is changing, as Indonesia, Sri Lanka, and Taiwan have announced they are decreasing their subsidies, as the cost is simply too much. Malaysia now spends 25% of its budget on oil subsidies, and must raise prices or cut other services – or watch inflation get worse. India is now contemplating how to cut its subsidies. Even China is likely to start to raise costs after the Olympics. These countries are going to go through their own price shocks. All this will reduce world demand for oil.

Inflation rises in the UK will have a devastating effect, says Ben Traynor in Fleet Street Daily:

Once inflation starts to rise, consumers notice. How can we not – we all have to buy things. And – with the exception of the terminally unobservant – we notice when the prices of things we buy go up.

And when there’s an expectation that prices will rise, there’s a very great likelihood that they will rise. The main mechanism that drives this process is wage demands. Faced with a rising cost of living, people ask their employers for more money. If employers refuse, they’re left with an unhappy and truculent workforce. Not good for businesses.

But if employers concede, their profit margins are squeezed. In order to maintain profits, they pass the cost of their increased wage bill onto the consumer, in the form of higher prices. Voilà! We have inflation.

Then, the whole dance begins again. This is the classic wage-price spiral. It is through this mechanism that higher inflation tends to beget higher inflation. We’re seeing it right now – prices rising, and consumers factoring that into their expectations.

So what can the Bank do? Simple – slam the brakes on! Confound those expectations!

The bond market has priced in three rate rises over the rest of the year. Why not just do them all at once? Send a clear message that the Bank means business. We’ll see an immediate inflow of funds into sterling, and a stronger pound will make imported commodities like food and oil less expensive for us.

Of course, a steep rate rise will play havoc with the housing market. But last I looked, that was on the critical list anyway.

However you look at it, the economy’s in a bind. We’ve had some good years. Now we’re going to have some bad. Boom and bust never went away, whatever New Labour might have told us to the contrary.

Either we raise rates, and people (especially those with loans to repay, such a mortgages) feel poorer. Or we allow inflation to keep creeping up. Faced with ever rising prices, people will feel poorer.

Some of those who feel poorer will, depending on their line of work, ask for a pay rise. Of those, a significant number will be knocked back, or offered something they deem unsatisfactory. Today sees the start of the Shell tanker drivers’ strike – a four-day bid to secure a 12.5% pay rise.

But this won’t be the last strike we see this year. Things will get really interesting when public sector unions decide to take on Brown’s weak government…

Get ready for some dramas.

President Nixon instated price controls on the 15^th of August, 1971. Inflation was a little over 4% at the time. Price controls manifestly did not work (resulting in shortages of all sorts and a deep recession) and were rescinded a few years later. President Ford went to Congress with programs to fight inflation that was running closer to 10% in October of 1974, with a speech entitled “Whip Inflation Now” (WIN). He famously urged Americans to wear “WIN” buttons. That policy too was less than effective, and the buttons, in a history replete with silly gestures by governments, should stand on anyone’s top ten list of such silly gestures.

Cynics more thoughtfully wore the buttons upside down and said the inverted letters (which looked like NIM) stood for “No Immediate Miracles.” They were right. There was no miracle, just eventual pain and lots of it. Ultimately, Paul Volker defeated inflation, but at the cost of two serious recessions and a lot of economic misery, with unemployment levels over 10% for nine months in 1983.

This week we were given the data that inflation as measured by the Consumer Price Index (CPI) over the last year was 4.2% and unemployment is now 5.5%. Some call for the Fed to raise rates so that we do not have to experience another lost decade like the ’70s and then ultimately see some future Volker forced to raise rates and drive unemployment back to 10%. Others suggest that “core” inflation is what should be paid heed to, and urge caution.

This week we look at the cost of what could be a renewed effort to Whip Inflation Now, not just here but in countries worldwide. Will Trichet in Europe raise rates even as the European economy seems to be slowing down? If you think inflation is bad in the US and Europe, take a peek at Asia. And I ask, “What will Ben do?” It should make for an interesting letter.

Whip Inflation Now

Nixon and his advisors thought inflation at 4% was serious enough to institute price controls. Headline inflation in the US is now 4.2%. What kind of economic policy should we pursue to bring inflation back into the Fed’s comfort zone of 1-2%? Would it work and would it be worth the pain? To get a handle on the question, let’s go to the data from the Bureau of Labor Statistics and see where inflation is coming from.

And let me note, this is the same exercise we could do for a host of countries. The answer will be roughly the same: there are no easy solutions.

Core inflation, or inflation without food and energy, grew at 2.3%. Inflation without food costs was an even 4% and without energy was 2.7%. Clearly energy was the leading contributor to inflation in the past year.

But the recent trend in rising inflation is even more worrying. If you look at just the last three months of data and compute an annualized rate of inflation, you find that overall inflation has risen to 4.9%, energy inflation is running at a staggering 28%, and food costs have risen 6.2%. Meanwhile, core inflation during that period dropped to 1.8%. You can see all the data at http://www.bls.gov/news.release/cpi.nr0.htm.

Now, gentle reader, let’s think about these numbers. Food (over 14%) and energy (over 9%) combined make up roughly 24% of the CPI, yet were responsible for over 60% of the recent three-month trend in inflation. By the way, housing was up 4.9% and transportation up 8.7%, so it was not just food and energy.

What would it take to drop headline inflation back to under 2%? Well, one way would be for food and energy prices to fall. Let’s look at the possibilities.

As Donald Coxe has noted, North America has had an 18-year run of remarkably good weather in our growing season. You have to go back 800 years to get a string of years that were that good. Yet today food reserves of all types are at decades-long lows. There is very little room for any type of problem.

This growing season is not off to a good start. It looks like the yield on the corn crop will be lower than normal, and that is if we get very benign weather this fall. Given how late much of the US corn crop was planted, and how torrential rains in the corn belt have devastated crops (not to mention flooding cities, and our thoughts and prayers go out to those who have lost their homes to flooding), an early frost would be disastrous.

Because we have devoted so much of our arable land to corn (in a very misguided policy to turn food into ethanol), we have less for soybeans, which is putting upward price pressure on beans and other grains that are used to feed cattle, hogs, chickens, etc. In fact, it costs so much to feed livestock that ranchers are shrinking their herds.. This means more meat is coming into the system now, which is dampening prices. Increased supply will reduce prices in the short term, but next fall we will find that supplies of all types of meat will be short. That will potentially send meat prices soaring. Cereal and bakery products are up 10% over the last year. They could continue to rise in the fall if the corn crop does not yield more than currently projected. It will cost even more to feed your household and feed the animals we need for meat.

Food is the most basic of commodities. Demand is fairly consistent, and supplies may come under pressure. Looking for food inflation to drop back by the fall to 2% is not realistic in the current environment.

What about energy? There is some more hope there, at least on the oil front. High prices have reduced demand in the US, with gasoline usage down about 4%.

I think we have reached a tipping point. The psyche of the US consumer has been permanently scarred. Slowly, this country is going to replace its fleet of cars with smaller, more fuel-efficient cars. Over time, we will see demand continue to fall. We could see further drops in the demand for gas in the next few months.

Much of Asia used to subsidize oil prices to their consumers. That is changing, as Indonesia, Sri Lanka, and Taiwan have announced they are decreasing their subsidies, as the cost is simply too much. Malaysia now spends 25% of its budget on oil subsidies, and must raise prices or cut other services – or watch inflation get worse. India is now contemplating how to cut its subsidies. Even China is likely to start to raise costs after the Olympics. These countries are going to go through their own price shocks. All this will reduce world demand for oil.

Here’s what he might write:

Dear Alistair

Hiya! It’s me! Mervyn King, Governor of the Bank of England. As you know, it’s our job to keep inflation stable – at around 2.0% as measured by the Consumer Price Index. If it goes below 1.0% or above 3.0%, I have to write you a letter explaining why.

Guess what! It’s gone above 3.0%. So this is that letter. Here goes…

There’s no easy way to say this, but I reckon it’s all your boss’s fault. As Chancellor, he presided over a massive credit binge, which is inflationary. He also allowed public spending to grow ahead of inflation. That’s inflationary too.

When we had steady growth and stable prices, he was happy to stand up and take a cheeky bow. Now we have slowing growth and rising prices. Personally I reckon you, or your boss, should be writing a letter to me, not the other way round.

But anyway, there’s your answer. We missed our target because your boss is a clown.

Cheers

Merv

PS I’ll be invoicing the Treasury for the cost of this stamp. I’m not made of money, you know!

On second thoughts, he probably won’t write that. But I bet he wants to! So… why am I certain that the Bank will miss its target? Because yesterday the results of its quarterly Inflation Attitude Survey came out.

The average Briton reckons the true inflation figure right now is 4.9%. And they reckon it’ll average 4.3% for this year. Compare these figures to February. The average respondent then thought inflation was running at 3.9% per year, and would average 3.3% in 2008.

This is a massive jump. It tells us that the Bank of England is losing the battle when it comes to influencing inflation expectations. And these expectations matter.

Inflation has a tendency to be what economists call positively autocorrelated. What this means is that high inflation in one time period tends to be followed by high inflation in a second, subsequent time period (we would call it negative autocorrelation if the opposite were true, i.e. we saw a high-low-high-low pattern).

Here’s how this works. Once inflation starts to rise, consumers notice. How can we not – we all have to buy things. And – with the exception of the terminally unobservant – we notice when the prices of things we buy go up.

And when there’s an expectation that prices will rise, there’s a very great likelihood that they will rise. The main mechanism that drives this process is wage demands. Faced with a rising cost of living, people ask their employers for more money. If employers refuse, they’re left with an unhappy and truculent workforce. Not good for businesses.

But if employers concede, their profit margins are squeezed. In order to maintain profits, they pass the cost of their increased wage bill onto the consumer, in the form of higher prices. Voilà! We have inflation.

Then, the whole dance begins again. This is the classic wage-price spiral. It is through this mechanism that higher inflation tends to beget higher inflation. We’re seeing it right now – prices rising, and consumers factoring that into their expectations.

So what can the Bank do? Simple – slam the brakes on! Confound those expectations!

The bond market has priced in three rate rises over the rest of the year. Why not just do them all at once? Send a clear message that the Bank means business. We’ll see an immediate inflow of funds into sterling, and a stronger pound will make imported commodities like food and oil less expensive for us.

Of course, a steep rate rise will play havoc with the housing market. But last I looked, that was on the critical list anyway.

However you look at it, the economy’s in a bind. We’ve had some good years. Now we’re going to have some bad. Boom and bust never went away, whatever New Labour might have told us to the contrary.

Either we raise rates, and people (especially those with loans to repay, such a mortgages) feel poorer. Or we allow inflation to keep creeping up. Faced with ever rising prices, people will feel poorer.

Some of those who feel poorer will, depending on their line of work, ask for a pay rise. Of those, a significant number will be knocked back, or offered something they deem unsatisfactory. Today sees the start of the Shell tanker drivers’ strike – a four-day bid to secure a 12.5% pay rise.

But this won’t be the last strike we see this year. Things will get really interesting when public sector unions decide to take on Brown’s weak government…

Get ready for some dramas.

How a €20 bribe unlocked Central Africa’s long-lost treasures

‘Let me tell you a story,’ writes Manraaj Singh in today’s Profit Hunter. ‘It’s about how one simple €20 investment could end-up paying back billions…

‘It didn’t happen on Wall Street or in the City…instead, it happened in a Belgian museum…’

As any mining start-up will tell you, exploration is a dicey business. It’s a safe bet that Central Africa has vast mineral wealth – but where, exactly?

Ordinarily it would take years of searching in malaria-infested jungles. But the Chinese have done something very clever. You see, there’s a museum in Belgium which houses maps dating back to the days of the Belgian Congo. One of things these maps show is – you’ve guessed it – the best place to mine for various minerals.

When a group of Chinese ‘tourists’ showed up at the museum, staff could be forgiven for thinking they were just another group of harmless holidaymakers.

But the souvenirs these guys wanted weren’t to be found in the museum gift shop…

Manraaj Singh has the full story in today’s FREE edition of Profit Hunter. Find out more HERE

Oh, and to the young man who threw a strop at South Kensington – there really was no more room in the carriage. You can’t expect someone to give up their place to you just because you’ve got gelled hair and an expensive tie.

Anyway. To business…

Central banking street fighter Jean-Claude Trichet’s been saying words again. The Times reports this morning that the European Central Bank (ECB) has “issued a surprise warning that surging inflation could force it to lift eurozone rates as early as next month”.

What surprise? Inflation in the eurozone, as in Britain, is a clear and present danger. It’s a real sign of the times that some of us are surprised when monetary policymakers propose to do something about it.

The general expectation is that if the ECB raise rates, the Bank of England will follow. I concur. I also expect our boys to raise rates even if the ECB doesn’t.

Why? Well, the latest Consumer Price Index figures show CPI inflation at 3.0% for the year to April. CPI, of course, is the inflation index against which the Bank of England is judged. It’s the Bank’s job to ensure that the figure never gets above… 3.0%.

Oh. The Bank’s on a knife-edge. And if the ECB does raise rates, the Bank will have to follow. The pound has been taking a hammering in the last year. Against the euro it’s down from around €1.47 to the pound this time last year to €1.25 this morning.

Inflation is the natural consequence of a weak currency. The principal reason for this is that a weak currency makes imports more expensive. This is exactly what’s happening in Britain – everything from food to energy is getting dearer. If the ECB puts its rates up, more money will head into the euro, further weakening the pound. Unless… unless the Bank of England also raises rates. Truth be told, the Bank should raise rates anyway. At July’s meeting they should announce a rise of 0.5% at least.

Not that they will. Because today we have yet more ‘bad data’ from the housing market. House prices are falling twice as fast as they did in the early nineties. According to the Halifax, house prices fell by 2.4% last month, to add to the 1.3% fall we had in April and the 2.5% fall in March.

Since January, the average house is worth 6.6% less. That works out at a not-too-clever £13,000 (Yesterday, Theo took an in-depth look at the housing market, calculating housing’s “P/E ratio”)

So an interest rate megahike is unlikely. But one thing is certain – the Bank of England can’t save the housing market. So it shouldn’t try.

Predictions time! When can we expect rates to start rising? For July, I reckon the Bank will stay put, leaving rates at 5%. Of course, that all depends on a) how much deflationary data we get this month, and how much the Bank can stomach, and b) whether or not the politicians try to meddle, and how successful they are if they do.

Milton Friedman once wrote that inflation is a problem because the more volatile prices are, the less efficient is the price mechanism. Because no-one knows what’s going on.

As he put it: “The broadcast about relative prices is, as it were, being jammed by the noise coming from the inflation broadcast”.

By August I think that noise will become too loud for the Bank to ignore. And then we’ll see some action (though probably only of the quarter-point variety; they’re cautious, these central bankers).

From our perspective, then, it’s as you were. Little succour in sight for the UK economy. But a possible chink of light that the Bank may, by hook or by crook, soon begin to start taking inflation seriously.

That is, if it isn’t too busy wrangling over the nice shiny ‘present’ the Chancellor wants to give them…

Darling, you shouldn’t have!

It’s always the quiet ones you should watch. They may be meek and demure, but they can have fiery tempers.

Sure, Bank of England Governor Mervyn King might look like a public school bursar, but if you push him too far, he might just kick off.

The Bank has its Monetary Policy Committee to oversee prices and inflation. Alistair Eyebrows thinks it needs a similar committee to look after “financial stability”.

Eyebrows wants to “bring in outside expertise to assist the Governor”.

This is just a bit of niggle, isn’t it? Another move calculated to wind King up… to what end I’m not quite sure.

But the Treasury wants to be careful. Because I don’t think they’ll like King when he’s angry…

Why Manraaj Singh is like Bruce Lee

OK, I’ll come clean – I only wrote that headline because I watched Enter The Dragon last night. And because Manraaj was telling me about China this morning (which is why the phrase ‘Enter The Dragon’ popped into my mind).

But now that I think about it, Manraaj is a bit like Bruce Lee…

Only, instead of dedicating his life to the perfection of martial arts – as Lee did by developing Jeet Kune Do – Manraaj’s ‘Tao’ is the world of overseas investing.

He’s made it his mission to turn this exciting field into a highly polished art form. And believe me, Manraaj has investment moves that leave most financial experts clutching their portfolios in pain…

Today, he’s looking at China. And he’s playing it through Africa.

Confused? I was… at first. But then the man himself explained it:

“If you’ve got something, and China wants it – pow! It’s profit town!”

Africa has A LOT of stuff that China wants. And Manraaj knows what that stuff is, where it is and – most importantly – how to invest in it!

Find out how you can pack your portfolio with all the power of a Bruce Lee flying kick – starting with an investment in the new King of African Oil…