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Market Update

5 Early Warning Signs of Inflation

Utility stock prices, commodity prices, and wages are among the early indicators, says John Waggoner.

If you ever want to get lots of nasty comments online, all you have to do is mention that consumer prices in the U.S.--including food and energy--have fallen 0.2% in the 12 months ended April 30. You'll get howls of protest from people who eat food (up 2%), enjoy shelter (up 3%), or need medical care (up 2.6%).

Whatever your personal rate of inflation is, however, it's the government's consumer price index that matters for investors, at least in the short to intermediate term. In particular, it's the consumer price index that excludes food and energy that garners the most attention on Wall Street. (For the record, that's up 1.8% the past 12 months.)

The inflation rate is important because the basic aim of investing is to have your money grow faster than inflation. You want your money to have greater purchasing power than it does now, not less.

Another reason to keep an eye on inflation is that the Federal Reserve likes inflation as much as Dracula likes watching the sunrise. When the Fed thinks inflation is likely, it raises interest rates to slow the economy and slow inflation. Higher interest rates are poison for bonds and, if they rise far enough, toxic for stocks as well.

How, then, do you know when inflation is coming? Forecasting is more an art than a science, as any economist will tell you. But you can keep a checklist of several early warning signs of inflation. Any good list would include the following.

Utility Stock Prices
Utilities are known for their relatively stable share prices and above-average dividends. For that reason, they have long been considered bond proxies--essentially, a stock that behaves like a bond. When interest rates rise, utility dividends look less interesting to investors than newly issued bonds or even bank CDs.

Because stock prices look forward, not backward, a prolonged sell-off in utility stocks can represent a Wall Street consensus that interest rates--and, therefore, inflation--is likely to rise. A sustained rise in the yield on the bellwether 10-year Treasury note can mean the same thing.

The problem with security prices as an inflation gauge: Wall Street can be notoriously shortsighted. You're looking for a significant, sustained drop in utilities prices, not just a one-week panic. Utilities stocks have gained about 1.7% the past 12 months, including reinvested dividends. While that's a considerable slowdown from their average annual gain of 13.5% the past five years, it's not bear-market territory yet--but it bears watching.

Commodity Prices
One early warning sign of inflation is an increase in raw-material prices, such as copper and lumber. These are economically sensitive materials: You need copper and lumber when there's plenty of new housing construction, for example. (Copper, incidentally, has been called "the metal with the Ph.D. in inflation.") A sharp increase in base commodities means that demand for raw materials outstrips supply.

So far, however, raw-material prices don't seem to be on the rise. Copper prices are more than a third lower than their peak in November 2010. Lumber prices are about 20% lower than their most recent peak in 2013. If there's any inflation in the air, base-commodity prices aren't reflecting it.

Precious Metals
Gold and silver are widely touted as hedges against inflation. After all, when people lose faith in the value of paper money, they look to tangible assets, such as gold, for their store of value.

If that's the case, inflation is deader than King Midas. Gold peaked at $1,895 per ounce in September 2011, according to gold dealer Kitco. As of this writing, it's selling for about $1,173. In most cases, gold rises when the dollar falls on the international currency markets. But a sustained rise in gold prices should at least be on your early inflation-warning radar.

Factory Capacity Utilization
When the economy is really humming, companies can no longer keep up with demand. One way to see how business is keeping up with demand is to look at factory capacity utilization, a figure produced by the Federal Reserve on the 15th of each month.

From 1974 through 2014, U.S. factories have operated at 80.1% of capacity. During the 2009 financial crisis, capacity swooned to 66%. Its most recent reading: 79% in April. Economists typically start to worry about inflationary pressures when factories are operating at about 84% of capacity. Right now, that doesn't seem to be a concern.

Wages
Inflation is defined, loosely, as too much money chasing too few goods and services. In other words, one condition for inflation is a large increase in the money supply. And ever since the collapse of Lehman Brothers in 2008, the Fed has been pumping unprecedented amounts of money into the system, both through its normal open-market operations and its three extraordinary bond-buying programs, called quantitative easing.

And the result has been ... very little inflation. When the Fed puts money into the system, it doesn't send $1,000 checks to everyone in the neighborhood. It buys government securities in the open market with freshly printed money, which increases the money supply. The real power of the Fed's monetary policy is that it reduces interest rates, making it cheaper for consumers and businesses to borrow.

But when business conditions are weak and unemployment is high, no one wants to borrow. For a business, there's no reason to build a new factory if the current one is running at half capacity. And consumers don't want to borrow if they're worried they might get laid off next month. When there's no demand, it's hard to get the economy jump-started by low rates, even if rates are at zero.

Economists speak of a wage-price spiral, which works like this: As demand increases, so do prices. As prices rise, employees demand higher wages. And, if the labor market is tight enough, they get high wages. That, in turn, pushes up prices.

To date, unemployment has been high enough to prevent a wage-price spiral, even though the official unemployment rate is 5.5%--traditionally, near what economists consider full employment. (Even in flush times, some people are unemployed).

But wage pressures could start to rise as older workers retire and drop out of the workforce, says Morningstar director of economic analysis Bob Johnson. And a recent survey by the National Federation of Independent Businesses says that 12% of small businesses are planning to hike wages in the next three months.

If you want extra credit for inflation-watching, you could monitor the monthly Job Openings and Labor Turnover Survey from the Department of Labor. The JOLTS report shows how many jobs were available: More jobs means a greater chance that the unemployment rate will fall. The most recent report showed 5.4 million job openings, the most since the series was created in 2000, Johnson says. "That's a pretty powerful number."

In recent months, companies have faced increasing pressure to raise wages, particularly for low-skilled jobs, where most of the U.S. job growth has been. So far, 21 states have raised or are scheduled to raise the minimum wage this year. Should the trend extend to higher-paying jobs, higher inflation--and higher interest rates--could be on the way by the end of the year.

Johnson is looking for inflation to clock in at 1.5% to 2% in December but thinks it could rise to 2.5% or even 3% by 2017. If you're interested in adding some inflation protection to your portfolio, check out this video from Morningstar director of personal finance Christine Benz. It's full of helpful tips for inflation-proofing.

John Waggoner is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.