Larry Kudlow

In my book “American Abundance,” published in 1998, I talked about the Four Dead Bodies theorem of inflation. Just as you should strongly suspect murder if you discover four dead bodies in an alley, you should be very wary of future inflation if four key market-price indicators are acting in unison. These include rising gold, a soft dollar, expanding bond spreads, and strong commodities. Right now, all point to inflationary money from the Fed.

Some of my supply-side colleagues have been warning of higher inflation for the last few years on the basis of three dead bodies: rising gold and commodity prices and a soft dollar index. But I have avoided the inflation call because the bond market hasn’t signaled a move to higher price indexes. Frankly, the bond market is a far more broad, deep, and resilient indicator than gold, commodities, or the dollar. Hence, it deserves a disproportionately high ranking in the body-count scheme.

Additionally, the Treasury bond has even greater analytical meaning because of the inflation-adjusted bonds (or TIPS) that trade in the open market. Basically, the 10-year Treasury bond can be deconstructed into a growth component (the real rate) and an inflation component (the TIPS spread). And so far this year the 10-year TIPS inflation spread has risen about 21 basis points, putting it above its 5-year average.

So is it the fourth dead body? Well, the modest widening of the TIPS inflation spread may be a weak signal of inflation risk. But it also may be confirming the other inflation warning signals. The Fed must take notice.

The JoC industrial metals index is up 16.5 percent year-to-date, gold is up 12 percent, and the dollar index has declined 3 percent. Added to this, the core inflation rate for the personal consumption price index (which is closely tracked by the Federal Reserve) has climbed from 1.4 percent last December to 2.8 percent in February on a 3-month annualized basis.

In short, the body count is climbing. Therefore, the Fed should maintain the current 5.25 percent fed funds rate in order to protect the value of the dollar and limit the risk of future inflation. Meanwhile, there is good reason to believe Fed chair Ben Bernanke is watching all of these indicators, with a particular emphasis on the TIPS spread. (He has revealed as much in speeches and congressional testimony.) If so, the chief detective on the inflation case may very well make the right policy call.

As he must.

Inflation is the bane of financial assets. Bonds lose value when future interest and principal payments are made in cheaper dollars. And stocks lose value when the rising interest rates necessary to compensate for inflation reduce the present value of future earnings.

Larry Kudlow

Lawrence Kudlow is host of CNBC’s “The Kudlow Report,” which airs nightly from 7 p.m. to 8 p.m.