- The Washington Times - Saturday, April 14, 2007

In my 1998 book “American Abundance,” I wrote about the Four Dead Bodies theorem of inflation. Just as you should strongly suspect murder if you discover four dead bodies in an alley, you should be very wary of future inflation if four key market-price indicators are acting in unison. These include rising gold, a soft dollar, expanding bond spreads and strong commodities. Right now, all point to inflationary money from the Fed.

Some of my supply-side colleagues have warned of higher inflation for the last few years on the basis of three dead bodies: rising gold and commodity prices and a soft dollar index. But I have avoided the inflation call because the bond market hasn’t signaled a move to higher price indexes. Frankly, the bond market is a far broader, deeper and more resilient indicator than gold, commodities or the dollar. Hence, it deserves a disproportionately high ranking in the body-count scheme.

Additionally, the Treasury bond has even greater analytical meaning because of the inflation-adjusted bonds (or TIPS) that trade in the open market. Basically, the 10-year Treasury bond can be deconstructed into a growth component (the real rate) and an inflation component (the TIPS spread). And so far this year the 10-year TIPS inflation spread has risen about 21 basis points, putting it above its five-year average.

So is it the fourth dead body? Well, the modest widening of the TIPS inflation spread may be a weak signal of inflation risk. But it also may confirm the other inflation warning signals. The Fed must take notice.

The Journal of Commerce industrial metals index is up 16 percent year-to-date, gold is up 12 percent and the dollar index has declined 3 percent. The core inflation rate for the personal consumption price index (closely tracked by the Federal Reserve) has climbed from 1.4 percent last December to 2.8 percent in February on a three-month annualized basis.

In short, the body count is climbing. Therefore, the Fed should maintain the current 51/4 percent Fed funds rate to protect the dollar’s value and limit the risk of future inflation. Meanwhile, there is good reason to believe Fed Chairman Ben Bernanke is watching all these indicators, with a particular emphasis on the TIPS spread. (He has revealed as much in speeches and congressional testimony.) If so, the chief detective on the inflation case may well make the right policy call. As he must.

Inflation is the bane of financial assets. Bonds lose value when future interest and principal payments are made in cheaper dollars. And stocks lose value when the rising interest rates necessary to compensate for inflation reduce the present value of future earnings.

Since the capital-gains tax is not indexed for inflation, significantly higher inflation elevates the effective tax rate on real stock-market capital gains. Think of it as an inflation tax on top of statutory cap-gains taxes. Further, higher inflation raises capital costs for businesses and reduces consumer purchasing power for individuals. It doesn’t matter if you’re the head of a family or a business chief executive officer, those greenbacks in your bank account are worth a lot less when inflation rises.

Here’s another problem: Contrary to the Keynesian/Phillips-curve dogma, economic slowdowns do not necessarily lower inflation. If the economy’s output of goods and services continues to slow, the existing money stock will become more inflationary in relation to the scarcity of goods. This would weaken the dollar and raise inflation.

Today the housing slump and a slowdown in business investment are both drags on the economy. Yet inflation remains a threat. We’ve seen this before: During the 1990-91 recession, inflation actually increased by 4 percent. Back a couple decades, 1980-‘82, when the economy was in recession, the inflation rate was nearly 8 percent. Milton Friedman labeled this inflationary recession. However, during the 1992-‘99 economic boom, inflation was only 2 percent annually. When the Reagan boom took over, inflation eased to about 3 percent.

In other words, bad money causes inflation, not strong economic growth. But a strong dollar will curb inflation.

There is loose talk from a protectionist-leaning Congress for a lower dollar to curb the trade deficit. This would be exactly the wrong policy. The Fed should ignore this banter and instead keep its eye on all four dead bodies in the inflationary morgue.

Lawrence Kudlow is host of CNBC’s “Kudlow & Company” and is a nationally syndicated columnist.

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