Investors Beware: Inflation Is Creeping In

gasoline gas station

Prices for goods and services are rising, which can be bad news for consumers and for investors.

The Consumer Price Index climbed 0.5 per cent on a seasonally adjusted basis from November to December, the largest monthly increase since June 2009, according to the Bureau of labour Statistics.

The increase was largely the result of higher gasoline prices, but prices also jumped for home heating oil, fruits and vegetables, sugar and sweets, and public transportation.

However, the so-called core rate of inflation, which excludes food and energy, climbed just 0.1 per cent, suggesting that prices for most goods and services remain stable.

This latest inflation report will likely support Ben Bernanke and the Federal Reserve and convince them to stay the course on quantitative easing and record low interest rates. Nonetheless, most investors should be at least a little uneasy for several reasons.

First, energy and food account for a large portion of most consumers’ budgets. When their prices go up, consumers have less money to spend on other things, which could derail the still anemic economic recovery that is just getting underway. Second, high energy prices will eventually make their way into the prices of all kinds of goods because energy represents a major expense for most manufacturers. Finally, focusing so much attention on the core rate of inflation is missing the forest for the trees. It’s like saying there is no inflation if we just ignore those things whose prices are going up.

One surprise from the December report was that apparel prices remained subdued. However, with cotton prices surging and inflation rising in China, U.S. clothing prices are bound to go higher. Cotton has recently been pushing $1.50 per pound, up from just 40 cents per pound in late 2008. Over the long run, higher prices should prompt farmers to plant more cotton, eventually causing prices to ease, but they’re not likely to go back to 2008 levels. In the short run, cotton prices could rise further, especially since flooding in Australia has wiped out some of its cotton crop. And with inflation in China now running more than 5 per cent, the days of dirt cheap imports may be over.

So far, most apparel makers have been taking this in stride. They have been absorbing higher cotton prices because in a still weak economy plagued with high unemployment, they are reluctant to pass them on to consumers. However, they may not be able to hold out much longer as their profit margins get squeezed. Jeans makers are among those most at risk. For example, VF Corp., which makes lower-priced brands such as Lee and Wrangler, is already planning to raise prices to counter the higher cost of cotton.

It’s not just apparel makers facing such challenges. Manufacturers of other products, from autos to chemicals to plastics, also will be hit. So will industrial companies and electronics manufacturers that rely on copper, another commodity hit with severe cost inflation.

Because the Fed has long been worried about the deleterious effects of deflation, it would no doubt welcome a healthy dose of core inflation. The Fed assures us it will act quickly to tame rising inflation when the time comes. Meanwhile, lower profit margins may put a damper on stock prices and bond prices typically fall when inflation rises. Bond investors in particular should take the Fed’s assurances with a grain of salt. Just don’t use the kind that melts snow on the roads. After all, road salt prices are way up, too.

This post originally appeared in The Fiscal Times.

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