Last week, the price of oil hit $127 a barrel. Oil imports to the United States cost 67% more this year than last. Imports other than oil rose more than 6% – or three times the Fed’s key lending rate. Steel has shot up too – almost 50% in the last 12 months. And gold rose a full $19 on Friday...it’s practically back at $900.

Naturally, the papers are squawking about inflation today. The Financial Times worries that inflation is going to undermine pensions and retirement plans. The International Herald Tribune , meanwhile, says inflation is undermining central banks’ efforts to...well...cause inflation!

Wait – we know what you’re thinking. Something is very wrong with a world where central banks cannot cause inflation any time they want to. Next, they’ll be telling us that you can’t have a cigarette when you want one...

But the papers are full of remarkable things...so why not? Besides, there are so many petards in central banking anyway; Bernanke and company were bound to get hoisted on one of them.

A society has no more real savings (resources set aside) than it actually has. And it sets interest rates (the price of those savings) as it sets any other price – on the basis of supply and demand. When the Fed intervenes with artificially low rates, it is merely pretending that it has resources available that it does not actually have. That is the trick known popularly as “inflation,” in which the supply of purchasing power is inflated with money that doesn’t exist.

Since the beginning of the credit crisis last summer, Fed policy has been purely inflationary – intended to convince people that they had more money and credit than they thought...and that they should spend it and invest it. But that policy can’t work forever. Eventually, consumer prices rise sharply. Then, the game is over...the Fed has to “lower inflation expectations” before it can inflate again. The hocus pocus only has a positive effect, in other words, as long as people are misled...once they catch, the jig is up.

And here we beg readers’ attention of a moment of deeper thought. This classical, cynical view of inflation seemed to be wrong for so long people began to think it was wrong forever. An entire generation has grown up with 1) a dollar with no connection to gold, 2) a dollar that actually rose against gold for 20 years, 3) Wal-Mart’s Every Day Low Prices, 4) apparently inexhaustible supply of cheap labor 5) globalized markets and supply chains and 6) falling bond yields. No wonder people began to think that inflation was no problem...and never again would be. Central bankers claimed they could now control economic cycles so as to have growth without inflation...boom without bust...forever. But forever seems to have come to an end already.

“The specter of inflation has risen over financial markets...” begins the IHT story.

Central banks can only get away with making money easier to get when consumer prices are under control. When prices for gasoline, milk and margarine begin to rise, people get fussy. They want their central banks to stabilize prices. And central bankers themselves look at their lending rates and get a little embarrassed. “How come you’re lending money so cheap?” economists ask them.

The fear is that if inflation is allowed to get “out of control,” it takes harsh policies to bring it back in line. Harsh policies are what everyone wants to avoid...especially before an election.

Classical economics tells us that an asset price bubble is always followed by an asset price bust. Inflation is followed by deflation, in other words.

But in our funny, complicated world, we get both inflation and deflation at the same time. The last two big bubbles – in residential housing and the financial industry – are deflating. Prices are going down for both assets. But inflation-sensitive commodities, most notably oil and gold, have soared. And now prices seem be working their up all along the chain...from the oil wells, to the shipping containers, to the Chinese sweatshops, to the shelves of Wal-Mart. A photo in today’s paper, for example, shows a pump at a filling station in New York with diesel fuel over $5.

What this means to central bankers is that they have to watch it. They can’t cut rates so freely...not while consumer prices are rising. Instead, the pressure will be on the other side – to raise rates.

To the man on the street it means that he has to prepare to pay higher prices for everything.

And to investors? What does it mean? It means inflation will do the work the bear market hasn’t been willing to do – that it will reduce the real value of stocks and bonds, even if nominal prices remain steady. Tim Bond, of Barclay’s Capital says, “investors have to be prepared for a few very unpleasant years. Bonds of all types – aside from index-linked – have no place in portfolios at current yields. Equity exposure should be narrowed to resources, energy, industrial goods and services – and once the write offs are completed – financials.”

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.