For the best hedge against resurgent inflation, look at silver

Anyone who's just received a gas or electricity bill will not need convincing that the cost of living in the UK is going up noticeably. What is more surprising to those facing double-digit fare increases is that the headline rate of inflation in this country is still quite modest.

The increase in the all-items retail price index in the twelve months to November was only 3.3%. However, this outlook is destined to get worse.

The UK labour market is tight, with the unemployed claimant count at its lowest level for a generation. The burgeoning public sector is a key contributor to this state of affairs by luring workers away from the wealth-creating sector of the economy.

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The government's policies are stoking up inflation

This, coupled with higher national insurance charges, and spiralling employee benefits forced on employers from Downing Street, points to labour costs taking off in the service sector of the economy too. This is already feeding through in higher prices in the catering industry and household and leisure services.

Even Mervyn King, the governor of the Bank of England, warned that we cannot expect the remarkable stability in inflation that we have become used in recent years to continue forever.

Inflation is taking off. So it is sensible to have a hedge against inflation in your portfolio. Gold immediately springs to mind. But the gold price has been firm in recent months and other precious metals like platinum are at multi-year highs. But a poorer cousin in this sector has been overlooked. That's silver.

Historically the ratio of the gold price to the silver price per ounce has averaged around 16. The ratio now stands at 64.8, implying that silver is extremely cheap. The supply and demand fundamentals are pretty persuasive too. At around $6.70 per ounce, the silver price is not high enough to encourage investment in new mines. Accordingly, if demand exceeds supply from operating mines, then the shortfall has to be met by a drawdown of existing stocks.

Moreover some highly-regarded investors like Warren Buffett are rumoured to hold large amounts of silver.

2005 will be silver's year

We expect silver to belatedly join the rush into commodities. But there are two other things you should know. First, as the silver price is 1/64th of the gold price per oz, it is not convenient to store physically.

Secondly, you should not regard the $54/oz high seen in 1980 as an objective. Back then an enormously wealthy Texan family, the Hunts, tried to corner the silver market (at one point they controlled half the deliverable supply) and the price squeezed higher. In response individuals queued to melt down their family heirlooms. In the event the Hunts failed to establish a monopoly and the price of silver and the Hunt's fortune collapsed. They later were convicted of market manipulation. This is unlikely to happen again.

$10/oz looks a reasonable objective for silver. If you don't want the inconvenience of holding the physical metal, buying a future or buying silver by means of a spread bet may be the answer.

But remember with geared investments you can lose more than your initial outlay and beware that the silver market is choppy and volatile. A silver future would be at the riskier end of your portfolio and hence should constitute a modest part of it.

Mark Geoghegan is the Editor of the Fleet Street Letter, the UK's longest-running financial newsletter. To find out how to protect and grow your wealth in today's threatening investment environment, click here