by Archie M. Richards, Jr.
September 4, 2006

I've said before in these columns that inflation won't be a problem. An article in the August 24, 2006 issue of The Wall Street Journal by Dr. Arthur Laffer, a prominent economist I much admire, is supportive.

Investments that hedge against inflation, like gold, silver, and gold, have soared of late, partly in expectation that inflation will continue to rise. I suggest that all such inflation hedges be sold.

Here's the approach Laffer takes:

Say you lend $10,000 to the federal government for 10 years. Credit risk isn't a concern; you're sure that Uncle Sam will pay you back. The only issue is, what rate of interest will you charge?

For simplicity, we'll assume you don't need regular interest payments. The government can keep both the principal and the interest and pay back everything at the end - in effect a zero-coupon bond.

Here are the two elements that make up the rate of interest:

• You want to be paid for not being able to spend your money for 10 years. They call this the "real" interest rate. You decide on 3 percent a year. On this basis, you'll receive $3439 interest in 10 years, in addition to the return of your $10,000.

• You also want to be compensated for the inflation you expect over the next 10 years. You expect the buying power of your money to diminish by 2 percent a year. At that rate, goods and services you can buy today for $10,000 will cost $12,190 in 10 years. You want the extra 2 percent added to the interest rate to make up for the loss of the dollar's buying power. This is called the "inflation-expectation" rate.

The rate you charge Uncle Sam includes the 3-percent real rate and 2-percent inflation-expectation rate, totaling 5 percent. The combination is called the "nominal" rate.

Now let's look at actual U.S. Treasury markets for ten-year debt. Treasuries are active markets with thousands of participants. In any market, the more participants, the more you can rely on the implied predictions.

I say "markets" in plural, because there are two types of ten-year Treasuries, as follows:

• One market is the buying and selling of regular Treasury notes and bonds. The interest rate here represents the nominal rate, including both the real and the inflation-expectation rates.

• The other market is the buying and selling of TIPS, which is short for Treasury Inflation-Protected Securities. The interest rate for these bonds is the real rate and does not include inflation-expectations.
  (For a more complete description of TIPS click here)

The real rate and the inflation-expectation rate, as mentioned, total the nominal rate. We know the current real rate (TIPS), and we know the nominal rate (regular Treasuries). To find the inflation expectation, we need only subtract the real from the nominal.

Here are the latest numbers from Barron's:

• The current nominal rate on regular 10-year Treasuries is 4.79 percent.

• The current real rate on 10-year TIPS is 2.24 percent.

• The difference is 2.55 percent. We infer this to be the rate of inflation expected by all creditor of the U.S. government for the next 10 years.

Mr. Laffer's article displays graphs of all three rates from August 1999 to August 2006. His ending numbers for August 2006 are close to mine, because the time difference is only about a month.

Laffer's graphs show that the inferred inflation-expectation rate has been falling for the last several months. The inflation-expectation rate is now about the same as it was in August 2003 and also in early-2000.

According to this analysis, the thousands of buyers and sellers of U.S. Treasuries and TIPS do not expect inflation to surge to new highs. This is the most accurate prediction of inflation one can find.

If you own gold or other investments that hedge against inflation, you're wise to sell them. After people realize that inflation won't be a problem, the prices of those hedges will fall.