“Inflation is back!” that’s what the headlines are starting to say and what I have been predicting for some time. Why is it back? The all mighty U.S. economy is slowing and the E.U. is also so how could we be in an inflationary environment? First of all, this should not be a shock to anyone. Stagflation (high inflation with a stagnating economy) has happened before and there is no reason to think that it cannot happen again. In fact, the pieces are in place for just that scenario. The aggressive easing of monetary policy is doing very little to improve the credit crunch but it is putting downward pressure on the dollar and other soft currencies. How can you make money in this environment? As Mad Money’s Jim Cramer loves to say, “There is always a bull market somewhere.” Right now, that bull market is in commodities.

Is this not old news? Do we really want to get involved in commodities? They have already gone up so much and many of them are at or near all time highs. If you think you can be safe by buying a 10 year U.S. treasury at less than 4%, then your trips to the supermarket will be very painful in the coming years. There are several reasons why I do not think we are close to the end of the commodities bull market.

One reason is that we are still not at the mania that one can expect during the extreme of a major bull (or bear) market. Most of the talk on the major financial networks consists of stocks, real estate, some bonds, and some commodities. When all is said and done, commodities will be front and center of attention. Much like the dotcom boom or the real estate flipping bonanza, we are going to have a commodities frenzy. Don’t get me wrong, some of the mania has taken hold but it is going to be much more pronounced. We may also have some corrections along the way but that is normal in any bull market. Everyone and their mother will be trading commodities. When the cab driver or the shoeshine guy starts giving you advice which commodity to put your money in, then you know the end is probably imminent. We are not close to that point yet and the fundamentals of supply and demand point to higher prices in the years to come.

Let us start with the supply. Bear with me because I am going to have to oversimplify things in order to prevent writing a book. All three categories of commodities (energy, metals, and agriculture) are in very short supply. Oil supplies are stretched thin and most oil producing countries are at full productive capacity. About a month ago, Petrobas discovered a major source of light crude oil off the coast of Brazil but it was extremely deep and will be costly to extract and will take some time before it comes online. We have not discovered any other major sources of oil for some time and those sources that we have not tapped into are in regions where investment capital is not attracted to or gets stolen by politicians. We also do not know the real amount of oil in reserves to begin with and current prices may not reflect the true supply. None of the OPEC countries allow for independent audits of their oil supplies yet each country’s voting influence in OPEC meetings is determined by how much oil the country “has” in reserve. Let’s just trust Hugo Chavez when he tells us how much oil he has. Ironically, while this situation of liar’s poker might strive to improve each country’s political influence, it actually hurts them as a whole because it helps to overstate the total supply of oil and decrease the price and the revenues the cartel receives.

Most supplies of agricultural goods are at or near historical lows. Prices have been so cheap for so long that the proper capital has not been invested to maintain production and prepare for the increase in demand. Whatever limited supply there was has been further compromised by the increase in demand from Asia. We may be on the brink of a starvation epidemic in many parts of the world, especially if we have a case of very bad weather one year. According to the U.S. Department of Agriculture, world grain stockpiles fell to 53 days of supply last year which is the lowest level since record-keeping began in 1960. As government continue to promote alternative energy through corn and sugar based ethanol, this will deplete the supply available for eating and devote more arable land for these commodities and away from other needed to farm other agricultural goods. There is also the possibility that the U.S. and Europe come to some sort of agreement to lessen or remove much of their agricultural subsidies. Should this happen we should see supplies diminish even further.

The demand for agricultural commodities is unlikely to subside. Even in a global slowdown, people are unlikely to eat less and China and India will still have strong growth rates. As China and India consume more grain fed animals due to their rising incomes, we will continue to see rising demand for grain (and substitutes). In this environment and given that agricultural commodities have not risen to the extent that the other commodities have yet, agriculture is my favorite.

Metals should also be in very high demand over the next several years. Again, this is due to the strength in emerging markets, particularly China and India. I am not a huge gold bug. However, I would rather own gold than the U.S. dollar. But, I would also rather own a lot of food than a lot of gold. I also don’t like that everyone seems to be talking an awful lot about gold. Should we reach $1000 soon, we might see a consolidation but that does not mean that this bull market is finished. Commodities related to metals and energy could be more negatively impacted by a global slowdown than agriculture, which is one of the reasons why I favor agriculture.

All of the commodities will have one giant ally on their side: The Federal Reserve. Chairman Ben Bernanke has now publicly admitted that he is more concerned about growth than inflation so he will continue to aggressively increase the money supply. Many central banks around the world will follow his lead. The European Central Bank has been holding out somewhat but they will face a lot of political pressure from export industries as the Euro reaches nose bleed levels. Cash is no longer king in this environment. Commodities are king because they are the only hard assets in limited supply. I am not saying that you buy commodities at high leverage (buying using a lot of borrowed money) because I expect pullbacks along the way and they will wipe out aggressive positions but we need to take the threat of stagflation as very real and in my view probable.