Published: November 12, 2010

Imagine a world where a cup of coffee costs $10... and the following year, it costs $12. Imagine nearly everything starts going up in price, year after year. Where I live, folks call that inflation.

Sound far-fetched? Actually, it's already started.

Let's start by looking at what's happening to food prices. Corn prices are up 44% in the past year. Soybeans are up 22%; wheat is up 23%. Even sugar is up 24%. It's pretty clear something is going on here.

Because of those rising commodity costs, food companies are jacking up their prices to cope. As a result, expect to pay more for Big Macs, boxes of cereal and baking mixes, to name just a few things.

Two heavyweights have already weighed in. McDonald's (NYSE: MCD) said it would raise prices in the U.S. for the first time in more than a year. General Mills (NYSE: GIS), which makes Cheerios and Wheaties, said it will raise its prices for cereal and baking goods.

There are many more examples, but these two firms are bellwethers. More will follow in their footsteps. As they raise prices, inflation, as we commonly speak of it, will be here.

You won't see it in the consumer price index, a popular inflation index - not at first. It currently bumps along at about 2%. But you should know that the government doctors up the CPI like a pitcher putting scuff marks on the ball to make it behave unnaturally. The government has made many adjustments to how it calculates the CPI over the years. All of the adjustments aim to make the CPI lower. Economist John Williams tracks the unadjusted CPI. According to him, it's running at 8.5% already.

It's not just food commodities that are rising. If they were the only things going up, we might just say something unique is happening in the agricultural markets.

But the prices of many commodities are surging. Metal prices are also up. Copper, for example, is up 27% in the last 12 months. The prices of gold and silver are up 26% and 32%, respectively.

Clearly, something greater is at work here for all these commodities to be rising so swiftly together. The truth is we've seen this movie before.

I recently attended Grant's Fall Conference, held at the great old Plaza Hotel in New York. Marble and bronze decorate its halls and chambers. Amid the old-world splendor of the belle époque, Frank Byrd, the founder of Fielder Research, delivered a persuasive presentation arguing that what we are going through is a lot like the 1970s.

Unemployment was rising. And the CPI was actually coming down. Capital utilization was low, meaning there was a lot of slack in the economy. "Just before the great inflation," Byrd told us, "things looked more deflationary than inflationary.

In the autumn of 1971 - on the eve of the greatest inflation in America in the 20th century - most people didn't expect inflation at all. But three years later, the CPI hit 12%. The food CPI hit 20% in 1973. Are we setting up for another bout of 1970s style inflation? Byrd says absolutely.

There were five signposts in the 1970s that also exist today, Byrd maintains. In the 1960s, America began to pile up trade deficits. It consumed more than it produced. By 1971, foreigners started to cash in those dollars they accumulated, which forced the U.S. dollar off convertibility to gold at fixed prices and led to inflation at home. An eerily similar scenario could unfold today.

Secondly, money supply grew faster than the economy. The printing presses were running, in other words, to finance the government's fiscal deficits. We've got that too.

Third, commodity prices went up. Oil increased fourfold, for instance.

Fourth, the government stepped in with price controls and ham-fisted regulations. We have a big government today, too. As Byrd points out, transfer payments - such as Social Security - make up nearly 20% of Americans' disposable income today. Meaning, we've propped up consumption like never before.

Finally, bottlenecks and shortages emerged in the 1970s - think gas lines. We've seen that sporadically with the food crisis and oil spike in 2008.

Byrd goes further. And this is where his presentation introduces a novel element.

The environment of the 1970s discouraged investment, Byrd said, as inflation forced up interest rates, raising the cost of capital. You can see it in the falling dollar amounts companies invested during that period.

The last 30 years have been very different. Interest rates have been falling... and investment has been rising. A chart of the 10-year Treasury yield shows you all you need to know. It's been an era of cheap money getting cheaper. As Byrd said, "No chart better defines the past 30 years: A long secular trend of declining interest rates and a declining cost of capital. No one under the age of 53 has experienced a world with a rising cost of capital."

Keep in mind that investment trends often unfold slowly. And often, things happen exactly the way people least expect them to. Think about it: On the eve of the 1970s, the greatest inflation wave of the 20th century in America, investors were accepting Treasury yields of 4%. The bond market didn't anticipate the great inflation, and it doesn't today with the 10-year rate even lower, at 2.38%.

"Prices are liars," John Burbank, the bearded manager of Passport Capital likes to say. Prices today don't tell you about prices tomorrow. That is certainly true in the bond market.

Since high inflation is not widely discounted in the market, the effect it will have on certain investment could be big. This leads Byrd to say: "I believe being on the right side of the inflation question could be the single most important investment decision of the coming decade."

It may well be. And certain investments do better than others in this kind of environment.

I have been doing research on investments that will provide great inflation hedge... investments where profits will soar if inflation and interest rates pick up. And while there are a few opportunities I see in this space right now – most of them are too illiquid to talk about here (although I have just recommended one to my smaller group of Capital & Crisis readers). That said, I am working on some industry-wide ideas that I should be able to share with you shortly. Stay tuned...

-- Chris Mayer
Editor
Whiskey and Gunpowder

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Note: This article originally appeared on Penny Sleuth