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One of the biggest concerns for the market over the next 12 to 18 months will be the rising specter of inflation. Core world food prices have doubled over the last year, inflation in India and China is presenting challenges in those countries and inflation in the euro zone just hit a 29 month high.

Commodities are also on an historic run across the board. Inflation measures in the United States are less challenging on the surface, unless you look at food and energy prices. In addition, inflation is being hidden by a variety of measures. One of the most creative is the new and smaller packaging being rolled out by consumer brands throughout the food industry. This was detailed in a great article in the NY Times Saturday.

What makes this concern more worrying is how the federal government is exacerbating inflation and why this has to be one of major watch outs for the future health of the market, given what is already in the inflation pipeline. Government has contributed to future inflation increases in at least three ways:

FEDERAL RESERVE POLICY: Let’s start with the obvious. Federal Reserve policy has been extremely accommodative over the last few years. Given the duration of this accommodative policy, I fear the Federal Reserve has made some of the same errors that led directly to the tech bust of 2000 and the recent housing meltdown. More importantly, it drastically accelerated pumping liquidity into the market with Quantative Easing part deux (QE2). This program has pumped hundreds of billions of dollars into the system. Although it has had just minor positive impacts for economic and job growth, it has done a wonderful job of inflating assets; particularly commodities and high beta stocks. It will be very interesting how those asset classes are impacted as this fuel is withdrawn at the end of the second quarter.

ETHANOL: If there any part of federal policy that makes less sense than our ethanol policies, I would sure like to hear about it. Not only does the government spend tens of billions of tax dollars in providing subsidies to ethanol makers and corn farmers, but it is mandating use of a fuel that takes more energy to make than what it produces. Almost 40% of the American corn crop goes to ethanol production. Given corn’s status as a major input (feed) to meat production and staples, is it hardly surprising food inflation has accelerated? The sad part is there is a painfully easy solution to this misguided policy, move the Iowa caucuses to the middle of the primary season (I am only being mildly sarcastic here). We would surely be better off by getting rid of these subsidies while signing free trade agreements with Colombia, Panama and Korea and opening up those markets for increased agricultural exports.

ENERGY POLICY AND REGULATION: Another incoherent part of the federal bureaucracy that is indirectly driving inflation is our current energy policies and regulations. It is very odd to see our president cheering Brazil’s efforts to drill over 5 miles deep offshore to expand their oil output, while curtailing all new U.S. efforts in the Gulf of Mexico and Alaska. The irony of having offshore drilling 40 miles off the coast of Florida in the near future for Cuban interests and done with Chinese technology while our state of the art technology is bottled up by our own policy makers is breathtaking. We will spend hundreds of thousands of dollars in federal subsidies for each “green” job, but will not do less costly and more effective measures like expanding nuclear power (Japan has also set this back by a decade) or convert our long haul trailer fleet over to abundant natural gas. Given the long lead time needed to bring new sources of energy on line, increasing domestic production is being set back years and is another factor impacting the ramp up in the inflation pipeline.

WHAT TO DO: This is the $64 question. Let’s start with what not to do. Avoid bonds as long term interest rates are going up. Ordinarily, commodities would be the place to play. However, given their huge run up over the last 12 to 18 months, that ship may have sailed especially given the negative impact the withdrawal of QE2 is likely to have on this asset class at least in the short term. The best area to target might be to look at companies that have pricing power and have large exposure to faster growing economies in the developing world. Exxon (XOM), McDonald's (MCD) and Coke (KO) made be worth a look. Be careful out there.

Source: Federal Policies Are Stoking Inflation: Avoid Bonds, Buy Companies With Pricing Power