Random walk.

These days everyone on Wall Street is frantically gazing into his crystal ball to forecast where inflation is headed. I don't need a crystal ball. I get my information from Wayne Angell, the chief economist at Bear Stearns, and his assistants John Ryding and Melanie Hardy. Those who knew Angell in his Fed days know that he is a passionate goldbug. Now he and his team have developed a simple economic model based on fluctuations in the price of gold to predict future inflation trends.

Knowing nothing about any economic conditions or variables except today's price of gold, the Bear Stearns model can predict roughly 80 per cent of the change in the CPI over the next 12 months. For the number crunchers out there, here is the magic formula that unlocks the mystery of inflation: CPI next 12 months = -5.32 + 0.024 x price of gold today. The basic rule of thumb, which I hereby designate the Golden Rule, is that every $10-an-ounce increase in the price of gold translates into about a 0.2-percentage-point increase in the CPI rate over the next year.

And now here's what you've all been waiting for. What will be the inflation rate over the next 12 months, with gold now running at roughly $390 an ounce? Answer: 4 per cent. Should gold rise to $425, the forcecast for the year ahead moves up to nearly 5 per cent. And to think that most firms on Wall Street spend millions of dollars a year on ivory-tower economists and usually get the wrong answer.

* Another pessimistic inflation forecast comes from the monetarist camp. Spearheaded by Carnegie-Mellon economics professor and former Reagan advisor Allan Meltzer, the most recent meeting of the Shadow Open Market Committee concluded that inflation will rise to at least 3 1/2 per cent and could reach 5 per cent in the next year, compared to last year's subdued 2.7 per cent CPI rate.

The SOMC closely watches the monetary base - composed of bank reserves and currency - as the key monetary leading indicator of future inflation. From the end of 1991 to early 1994, base growth averaged an annual rate of 10 per cent, way too high, according to the Shadow group. It is critical of the Federal Reserve for not tightening policy a year ago and believes that the Fed's restraining actions earlier this year were much too timid. But the SOMC has been more impressed with recent Fed moves that have reduced monetary-base growth to an 8.2 per cent yearly rate over the past three months and 8.7 per cent over the past year.

Nevertheless, higher inflation is "baked in the cake," according to Professor Meltzer, and it remains to be seen if the central bank can gradually reduce yearly base growth to around 7 per cent, which would be consistent with the 0 to 2 per cent inflation target favored by the SOMC. Should the Fed overreact to near-term inflation numbers, which are likely to look quite bad, hopes for an economic soft landing will evaporate and recession will result.

For those with short memories, the hoped-for soft landing in 1989-90 turned into a nasty credit-crunch recession. This led voters to fire President Bush. Is Bill Clinton about to be Bush redux?

* What happens to the stock market if inflation marches higher? It can only be bad for stocks. Stock-market investors are very keen on realizing capital gains from their equity investment. But the U.S. tax treatment of these gains has never allowed inflation indexation. That means we pay taxes on the inflated nominal portion of the gain as well as the real gain. This in turn means that last year's 2.7 per cent inflation rate translated into a 53 per cent tax rate on real capital gains (2.7 per cent inflation x 3 per cent historic real return, multiplied by the 0.28 per cent tax rate, then divided by the 3 per cent real rate).

Of course, the 53 per cent effective rate is much higher than the 28 per cent statutory rate, but historical - going back to 1950 - an effective capital-gains rate below 60 per cent is actually bullish. During the bull markets of 1950 to 1966 and 1981 to the present, the effective capital-gains tax rate was indeed below 60 per cent. But the dreary 1966-1980 period of stagflation, which produced a long bear market, was characterized by high inflation and an effective capital-gains rate above 60 per cent, even reaching 120 per cent at times.

If inflation reaches 4 per cent, then today's 53 per cent effective capital-gains rate will jump to 65 per cent, representing an 18 per cent loss in the present discounted value of future wealth. From roughly 3900 on the Dow-Jones industrial average, this suggests a correction down to 3200. If inflation reaches 5 per cent and the effective capital-gains burden jumps to 75 per cent, then the Dow might drop to 2800.

Is there a nasty October surprise coming from the stock market? Newt Gingrich and Bob Dole won't mind, but Tom Foley surely will. Naturally, the timing of a major bear correction is impossible to predict, but a threatening trend is unmistakable. Cash looks very sexy to me right now. I think I am falling in love again.