Monday, December 27, 2010

Do Rising Commodity Prices Indicate Inflation on the Horizon?


The other day some friends of mine took their parents to see a local bank. Their aging parents, they felt, could benefit from some professional financial management, and this well-respected trust company seemed to fit the bill.

After the meeting my friends asked me to look at the material the bank had given their parents.

I'm not going to comment on the presentations of my competition (even though I would like to!), but I was struck by one aspect of the proposed plan:

"We will keep bond maturities very short in anticipation of higher interest rates ahead".

This is a very common theme among investment professionals: Interest rates are going to rise.

All you have to do, they argue, is look at the prices of commodities, which are roaring higher. Gold and copper in particular are usually cited as good harbingers of future inflation.

Well, maybe, but perhaps the rise in commodities is really more a function of an expanding world demanding more resources.

Paul Krugman's column this morning in the New York Times discusses this. Here's an excerpt, with the full link below:

What about commodity prices as a harbinger of inflation? Many commentators on the right have been predicting for years that the Federal Reserve, by printing lots of money — it’s not actually doing that, but that’s the accusation — is setting us up for severe inflation. Stagflation is coming, declared Representative Paul Ryan in February 2009; Glenn Beck has been warning about imminent hyperinflation since 2008.

Yet inflation has remained low. What’s an inflation worrier to do?

One response has been a proliferation of conspiracy theories, of claims that the government is suppressing the truth about rising prices. But lately many on the right have seized on rising commodity prices as proof that they were right all along, as a sign of high overall inflation just around the corner.

You do have to wonder what these people were thinking two years ago, when raw material prices were plunging. If the commodity-price rise of the past six months heralds runaway inflation, why didn’t the 50 percent decline in the second half of 2008 herald runaway deflation?

The Finite World - NYTimes.com

I continue to believe the larger risk to many investors - including the aging parents of my friends - is the possibility that interest rates remain lower than most anticipate. Keeping your money in a money market fund today in anticipation of higher rates ahead may seem like a sound strategy but it is also an expensive one.