Where there are higher oil prices, inflation will quickly follow.

It should be axiomatic. A foregone conclusion. Oil-that prehistoric stuff that drives 21st Century commerce-cannot jump in price without causing everything else to jump in price.

It's like the opposite of falling dominos. In this case, the dominos would be rising, one right after another.

"Inflation has been on an upward tilt the past couple of years. Now, the inflation rate is near the upper end of the Fed's tolerance zone, and shows little inclination to go in the other direction," observed Richard Fisher, president of the Federal Reserve Bank of Dallas.

Little inclination? That's Fed-speak for "inflation is getting out of control here." This is the same Federal Reserve Bank of Dallas that recently noted, "nine of the ten post-World-War-II recessions were preceded by sharply rising oil prices."

Not to be outdone, William Poole, the head Fed honcho in St. Louis admitted, "If the inflation environment becomes unhinged, that is going to lead to all sorts of unfortunate things in the real economy; it is going to make things less stable."

That's Fed-speak for "Better watch out!"

In a recent article, I detailed how rising oil preceded rising inflation-and rising interest rates and gold-in the 70s and 80s. I wrote:

"In 1980, oil prices reached $21/bbl due in large part to the second oil shock, Iran invading Iraq, and a drop in Iraq's oil production by a million barrels. Accordingly, that spurred inflation to 13.58 percent. The prime answered with an almost loan shark 20 percent rate on April 2nd. And gold? It hovered in the $500 vicinity on that April 2nd day, after setting the current $850/oz record a little over two months earlier (thereby smashing the $500, $600, $700 and $800 barriers)."

This very same inflationary stew is heating up in the last quarter of 2005. You can catch a whiff of it in a recent survey of business executives and in the diminishing purchases of Treasuries by foreigners.

The Institute of Supply Management just conducted a survey. The group reported that its "index of prices paid" rose 14.3 points to 81.4 percent. That's the highest level and biggest jump in the eight-year history of the index.

"It is troubling to see so many more purchasing managers, manufacturing and non-manufacturing, paying higher prices to their vendors," said one analyst. "It suggests that the Federal Reserve is faced with an economy which is weaker and inflation which is stronger. That is not a particularly good configuration."

And not particularly far from home, either. The "purchasing manager price level" is just six months or so away from you and me and the grocery store.

That those higher prices will soon hit us is a virtual slam dunk. Businesses-at least the ones intending to stay in business-certainly won't take the whole inflationary hit themselves. Paul Kasriel, an economist at Northern Trust in Chicago, asks, ''How long can businesses absorb these higher energy prices before some of them go out of business or aggressively pass through some of the costs?''

One repercussion of this higher inflation is the mounting concern over the $2 billion the U.S. needs each day just to stay solvent (note: the Organization for Economic Co-operation and Development thinks that daily amount is closer to $2.5 billion).

China and other nations serve their self-interest by providing these daily billions through the purchase of U.S. Treasuries. At least they have up to this point.

In August, according to the Bureau of Labor Statistics, "Petroleum-based energy costs increased at a 40.8 percent annual rate and charges for energy services rose at a 9.0 percent annual rate." Somehow, based on the past summer months, and in the mystical way the Consumer Price Index is concocted, our sky-high energy costs have only translated into a projected 4.9 percent annual inflation rate for "all items."

Even if we accept that figure, 10-year Treasuries are running at 4.25 percent. Do the math and you come up with a possible 0.65 percent negative yield.

Small wonder the sale of U.S. Treasuries are down. And not by just a little. From a peak annual rate of $400 billion in early 2004, Treasury sales have dropped to less than half that this year. And sales may drop by half again, if recent signals are any indication.

To add insult to the economic injury already done-and maybe as an ominous sign of thing to come-Venezuela just divested itself of about half of its $30 billion in mostly Treasuries.

I mentioned the inflationary stew earlier? Here are some of the irresistible ingredients going into it.

• Katrina. No doubt America's costliest natural disaster would be tough enough to swallow in a good year. This isn't a good year. One company, Risk Management Solutions, puts the insurance cost at between $40 and $60 billion (not including the inevitable higher premiums). Political advisor, Bill Hoagland, thinks the correlation between insurance and government costs in an emergency is less than 1 to 1. Still, Washington is throwing around a $200 billion figure as if billions were millions.



• Iraq War. The human toll is incalculable, the financial toll staggering. $7 billion a month is what a congressional report just determined. That's on top of the $1 billion a month for Afghanistan and the mega-billions already spent launching both campaigns.



• $60 Oil. According to the Wall Street Journal, "The increase to $60 a barrel from $40 a year ago has cost the U.S. economy about $75 billion." That's just for starters. As those increases wind their way through the economy like a venomous snake, the costs of food, among other things, will jump. One example, a California farmer named Don Cameron, decided not to grow wheat this year (according to a story in the San Francisco Chronicle). Higher fuel costs were the tipping point. "Could this be the tipping point for somebody (else)? It surely will be," Cameron said.

Adding up the above, you get somewhere in the vicinity of a third of a trillion dollars in "extra expenses" this last year. That's over and above the record deficits that have, among other things, eroded the dollar.

Charles de Vaulx, manager of the First Eagle Gold Fund, sees it pretty clearly. "Middle East nations are getting more petro-dollars as (oil) prices rise, and they're not putting it back into paper assets. They're trying to protect the value of their profits-just like in the 1970s-so they're buying gold."

Sounds like decent advice.

Kevin DeMeritt
www.goldcentral.com
October 11, 2005