We got more evidence today that inflation is not a serious concern. The Consumer Price Index (CPI) was unchanged in February after five straight months when it had increased by only 0.2% per month. Overall consumer prices are just 2.1% higher than a year ago.

If food and energy prices are stripped out to get “core” inflation, then inflation is also very tame, with core inflation up 0.1% in February, reversing a 0.1% decline in January and a 0.1% increase in December. Over the last year, core inflation has just been 1.3%, and most of that inflation happened earlier in 2009.

Actually, food prices have been very well behaved, down 0.2% over the last year, but up slightly (0.1%, 0.2%, and 0.1%) in each of the last three months. Energy prices have been the reason that overall inflation has been higher than the core, and more specifically energy commodity prices. Overall energy prices are up 14.4% over the last year.

Energy service prices, like electricity, are actually down a fairly sharp 4.2%. Energy commodity prices, like gasoline, have soared 34.4% over the last year as oil prices have rebounded. In February, overall energy prices fell 0.5%, but that did not come close to reversing the 2.8% increase in January, which in turn came on top of a 0.8% increase in December.

So far in March, crude prices have rallied, dragging the price of gasoline up, so it is highly likely that headline inflation will be much higher than core inflation when the March numbers are released next month.

Behind the Headline Numbers

The primary reason that core prices are so well controlled is the price of shelter, which was unchanged in February, and has not been in positive territory since August. By far the single largest component of the overall CPI is what is known as Owners Equivalent Rent, or OER. That is what the government figures homeowners are “paying themselves” to stay in the homes they own. Essentially it is what it would cost you to rent a similar house across the street from your current house.

OER makes up 25.2% of the overall CPI. Regular rent that tenants pay to landlords makes up an additional 6.0% of the index (the other very small components to shelter are the cost of hotels and homeowners insurance). Since rent is neither food nor energy, it makes up an even bigger portion of the core CPI (almost 40%). Over the last year, both OER and regular rent are up by just 0.3%, and both were unchanged in February.

With very high vacancy rates, it is unlikely that rents are going to start accelerating any time soon. This means that we are likely to see very tame inflation for some time to come now. That, in turn, gives the Fed the green light to keep short-term interest rates at extraordinarily low levels for an extended period of time.

Aside from energy, the major problem area with respect to prices is health care. The cost of medical commodities (i.e. drugs) is up 3.5% over the last year and were up 0.8% in February, on top of a 0.7% increase in January. The cost of medical services (doctor and hospital visits) is up 3.7% over the last year, and was up 0.4% in February on top of a 0.5% increase in January.

How to Play This

Unless you think that the trend will soon reverse, it is generally a good idea to have your investments favoring those firms that have the ability to raise prices, or at least benefit from rising prices. Thus providers of energy commodities, such as oil and gas exploration and production companies should be over-weighted.

Some large cap names to consider would be Petrobras (PBR) and Apache (APA). A smaller-cap name that is set to significantly increase its production is ATP Oil and Gas (ATPG) which looks interesting.

By the same token, the health care area looks interesting, especially as the sector has the lowest P/E ratio of any in the S&P 500 based on 2010 expected earnings. Two large cap names to consider there would be in the distribution area, Amerisource Bergen (ABC) and Cardinal Health (CAH).

Then again, it is a good idea to avoid firms where they have no pricing flexibility or prices are falling (Tech is an exception to this since prices are always falling due to Moore’s law). For example, while the energy commodity names look good, it might be a good idea to underweight the electric utilities, where prices have generally been falling.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

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