Setting up a hot summer of higher inflation

Americans have enjoyed a respite from inflation over the last few years. Not since the worst of the Arab Spring turmoil in 2011, when crude oil zoomed to $115 a barrel, has the specter of higher prices loomed.

Despite the Federal Reserve's ongoing money-printing stimulus, and the fact that the monetary base has swelled to nearly $3.8 trillion as a result, inflation has been largely nonexistent. The Fed's preferred measure of inflation has, over the last three months, averaged an annual growth rate of just 0.9 percent, down from a peak of 2.9 percent in September 2011.

But now, evidence is building that this could soon change -- setting the stage for a hot summer of higher prices.

The late Nobel laureate and economist Milton Friedman famously quipped that inflation is always and everywhere a monetary phenomenon. So it's been a bit of a head-scratcher that inflation has been so benign lately. There are many possible explanations, from fixed-asset overcapacity in China to moribund hiring here at home and a strong dollar.

Some of these factors are starting to shift. Mainly, the dollar has been weakening over the past week -- dropping out of a multimonth consolidation range that sets up a retest of lows touched in 2011.

The dollar plays a key role in inflation dynamics because of its status as the global reserve currency of choice. When it's strong, commodity prices tend to be low as do prices of imports to the U.S. Between mid-2011 and mid-2012, as the Fed slammed the brakes on its cheap money stimulus by ending the "QE2" bond purchase program, a stronger dollar helped unwind those inflationary pressures.

Between 2012 and now, the dollar drifted sideways.

But now, with the economic data -- from retail sales to industrial production to housing starts -- disappointing to the downside, the dollar is melting lower on expectations the Fed will halt its tapering of the ongoing "QE3" bond purchase program (which has seen its monthly run rate drop from $85 billion to $65 billion already) and/or pledge to keep short-term interest rates lower for longer.

The Wednesday release of the latest Fed meeting's minutes seemed to reinforce this thinking, with policymakers noting that while the unemployment rate has indeed fallen recently, alternative measures of the job market -- such as labor participation rates -- suggest much healing is still left to do.

And that's threatening to awaken inflation from its slumber. 

Moreover, it's not just the situation in the currency market or the vagaries of Fed policy that threaten to push prices higher. Extreme weather, especially the historic drought in California, looks ready to pinch consumers at the checkout stand.

The water situation in the Golden State is so severe that communities are considering trucking in drinking water as the mountain snowpack stands at just 12 percent of normal, making a parched summer almost certain. In what's normally a season of mountain runoff and reservoir refilling, Governor Jerry Brown has been forced to ask people to turn off the taps when brushing their teeth.

This is a problem because of how critical California's farms are to the nation's food supply. According to data from the California Department of Food and Agriculture, the state is the nation's largest producer, by value, of agriculture goods. It produces nearly half of U.S.-grown fruits, nuts and vegetables, and it dominates the production of many items.

California maintains an 80 percent or greater share of U.S. production of the following: artichokes, almonds, broccoli, celery, processed tomatoes, nectarines, strawberries, cauliflower, garlic, leaf lettuce, plums, apricots, grapes, figs, kiwifruit, lemons, olives, pistachios, dates, lemons, walnuts and peaches.

It'll be a big deal if the drought conditions don't end soon.

And finally, it's worth noting that the cattle market looks set to tighten as well. Extreme weather and the high price of corn between 2011 and early 2013 have decimated herds. Cattle counts have dropped for six consecutive years to the smallest size since 1952, according to government data. Already, cattle prices are up more than 11 percent from their 2013 lows.

For households, higher prices will further dampen retail spending and confidence. For investors, if inflation does indeed return, it'll bolster the recent strength seen in gold, silver and the related mining stocks as folks seek out hedges against a rise in prices.

Examples of the moves underway in this segment include Great Panther Silver (GPL), which is up 23 percent since I added it to my Edge Letter Sample Portfolio on Feb. 11. Silver Wheaton (SLW) is up 7 percent.

Of course, higher inflation would also force the Fed to tap the brakes and more aggressively scale back on its cheap money stimulus at a time when the market has grown increasingly dependent on it. 

Disclosure: Anthony has recommended SLW and GPL to his clients.

Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters as well as Mirhaydari Capital Management, a registered investment advisory firm.