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DOMINO DISTORTIONS FROM THE CPI & PCE

When the price inflation is distorted and falsely reported low, many consequences happen in effect. The grandest effect is to exaggerate economic growth (GDP). The Personal Consumption Expenditure (PCE) index used to build the “Deflator” in the Gross Domestic Product calculation seems to low-ball systemic price inflation even more than the CPI does for consumers!!! This is important, especially if you wish to promote a distorted picture of GDP with a motive to sell Treasury bonds or to seek political office. Any claim that the adjusted GDP is “real GDP” is simply Orwellian in its basis in truth. The end result is that perhaps half of reported GDP growth is a fiction. Many shams can easily be identified. They are invisible to those whose bloodlines are powered either by vested interest in the financial sector or by politically driven pumps.

Gross Domestic Product calculations are powered by several forces. Under-stated price inflation provides the greatest lift. Chain weighting compounds the understatement error. The adjusted GDP is amplified by hedonic methods, whose absurd lift in information technology spending creates an artificial world of accounting and reporting to the public. As computer speeds increase, so do the hedonic multipliers.

The CPI is kept low by ignoring numerous rising prices, such as property taxes, town usage fees (water, sewer, sanitation), professional services (doctor, dental, lawyer), home services (carpentry, plumbing, electrical, roofing), college tuition, restaurant meals, sports club fees, and more. In my view, the CPI has become little more than a measure intended to exploit the trend of falling imported finished product prices, in order to keep cost of living raises down in USGovt pensions of various types. As the USDollar shot skyward in the last decade, the CPI marched relentlessly toward zero. The backfire in politically inspired statistics comes when the Asian currencies break loose and rise with force. Such an event might be in progress now, as political pressure upon Japan and Europe can now subside after the presidential elections. The euro currency just made a multi-year high, as the Japanese yen currency just made a seven-month high. Foreign producers have begun to pass along higher costs, soon to be seen in finished product prices.

The CPI is intended to measure price inflation for consumers. The PCE index is intended to remove on a broader basis the systemic price inflation working throughout the entire US Economy. Distortions to under-state are perhaps worse in the PCE-related deflator for GDP statistics. Let us take a closer look.

MONETARY STIMULUS KEEPS CPI DOWN

The CPI puts 1/3 weight on home rents, but ignores home prices. It puts 1/3 weight on used cars, but ignores new car prices. Even a high school student would question this practice, but not Wall Street professionals. So artificially low interest rates provide federal subsidy of home mortgages, but dampen home rental costs, only to suppress the CPI further. So irresponsible finance deals at 0% with cash back encourage new car sales, but crush the user car market, only to suppress the CPI further. Never before has monetary stimulation with low interest rates actually resulted in the suppression of Consumer Prices Index statistics. It does now, and has been the case for three years running.

The CPI measures many items prone to decline from over-production in the real economy, while skipping over numerous items easily detected in the financial sector like home values, bond principal, and stock prices. The entire US Economy is a bubble, with explanatory statistics full of bold deception. Our financial system has become a total fraud, strong words, but backed up by defensible arguments. Good for politics, bad for reality checks, for business management, and retirement planning.

In the last 1990 decade, a monumental phenomenon took place on a macro level. The US Economy permitted grand debt expansion. This is technically monetary inflation, although the intermediation (official management of the credit extension) did not originate from big banks. As our debts grew, Asian productive capacity grew in the form of widespread manufacturing plants and shiny new equipment put on line. While US interest rates came down from the mid-teen percents in the mid-1980 decade, the decline in rates continued into the 1990 decade. The USDollar bull market, partly an echo of the new euro currency stumbled birth, enabled an acceleration of the reliance by the US Economy on Asian-made products. Hence, as US money supply accelerated, the CPI declined, as the US$ bull rally made foreign products cheaper each year. This is a statistical sham born out of monetary largesse, a temporary situation which is in the process of reversal.

THE PCE DEFLATOR APPLIED TO GDP

The Personal Consumer Expenditure index (PCE) is very similar to the CPI, and is used to treat inflation adjustments to the Gross Domestic Product (GDP). It is often called the “deflator.” First and foremost, an understated PCE permits the GDP to be overstated, since nominal (unadjusted) sales of goods & services are improperly and insufficiently pulled down to remove price inflation. Much of what is claimed as economic growth is simply untreated price inflation. We all paid more for gasoline this summer, but the PCE registered only a puny increase in personal costs. Be suspicious of higher GDP statistics when the quarter contained some obvious sources of rising costs not reflected in the deflator. Well, unless you want to promote the story of growth and resumed economic health, with political inspiration motivating your views.

Does anyone in his or her right mind truly believe price inflation has accumulated only 4.8% since January 2002???  At least the fiction of the CPI registers a 6.6% accumulated rise in consumer prices over that stretch of time. See the accompanying graph for a comparison of the Consumer Price Inflation versus the GDP Deflator. At least 80% of the American public perceives the CPI to be an under-statement low-ball of price inflation. Little do we realize that the GDP Deflator suppresses price inflation measurement even more. The immediate consequence is that much more of the GDP growth is pure poppycock, nonsense, crappola, rubbish, fiction, fantasy. Mere pablum for the newsprint and sales promotion.

Take an example as a lesson. Suppose prices uniformly rose 5% over an entire year across the entire economy, owing to the USDollar decline and rising prices for imports of materials and energy, in combination with massive printing of money by the USGovt. Suppose also that zero actual economic growth took place in a flat economy, as prices rose but no growth took place. The official adjustment might call for removal of only 2% of the price inflation. The end result of the deception is then claimed economic growth (via the GDP) reported at 3% when there was no growth at all. My personal analysis and assessment is that perhaps half of claimed economic growth inside the reported GDP is fictional, from improperly adjusted price inflation, that real GDP growth in the last few quarters has ranged somewhere between 1.5% and 2.5%, not 3.0% to 4.0% or more.

Furthermore, the PCE price deflator is applied in a chain weighted fashion, which means the distortion is compounded. Imagine compound interest accumulating for a savings account. You earn interest on your interest, as it gathers in amount with each passing period of calculation. Now reverse the concept and see the residue of unadjusted inflation in an accumulative fashion. The degree to which price inflation is NOT removed actually feeds upon itself. This serves to exaggerate and distort economic growth. Chain weighted calculations were a wonderful idea to amplify economic growth, instituted into the statistics several years ago. This is clearly a sham but also a shame.

HEDONICS REVISITED UPON THE GDP

The practice of hedonic adjustments, from faster computer and network speeds, amplifies the distortion in the GDP measurement. Faster computer processors, faster disk storage access, faster network routers and switches, and faster bandwidth over transmission lines and internet connections have encouraged the USGovt statisticians to amplify information technology sales figures by between 10 and 15 times. This practice is indescribably fraudulent, and adds at least 1% to 1.5% to the GDP growth rate. The practice of tech hedonics, in an attempt to integrate quality adjustments, has developed into an evolved magnificent deception in itself. Methods are honed on a regular basis in order to improve the false lift to economic growth, especially where the USA commands some degree of dominance. That segment is clearly the information technology arena. Spending in this segment has been exaggerated for many years. As speeds continue higher and higher, the degree of deceptive amplification of IT spending also rises. Hedonic multipliers applied six to eight years ago are perhaps only half of what are applied in 2004 GDP statistics. The trick is to deceive systematically, to amplify the exaggeration on a regular basis, but to make it so gradual that the practice is not exposed publicly as a fraud.

In the second half of the 1990 decade, computer software purchases no longer were accounted as expense items, whereby their cost was incurred over several years. Instead, software purchases were recorded in full. However, in 2002 a new twist took place. USGovt wizards decided to classify software in the same category ledger column as computer hardware. This move seemed harmless unless one examines the hedonic multiplier frequently discussed in essays written on the Financial Sense website. As hardware speeds grew tremendously, the prices of end products deployed in commercial establishments went down. Hedonic adjustments bring back that 20% gain in power via adjustments to the spending, even as the original cost fell 20%. So each $1 billion in computer hardware, networking equipment, storage devices, or fiberoptic connections is suddenly called several billion dollars since it performs much more work than in previous years. That is hardware, but what about software? Software was becoming more efficient as well, with UNIX portability, modular programming, and macro-driven routines adding to productivity. In some environments, computers are generating software code. Why not distort the software spending just like the hardware spending? That is exactly what happened two years ago. This is a sham.

Computer hardware and networking equipment now routinely enjoy the benefit of a quality adjustment multiplier. Hedonic adjustment methods have become a statistical cancer. In the famed Q3 of 2003, a mere $11 billion in sales helped the GDP by over $90 billion after the multiplier was applied. Statistical accounting methods, the close brother to financial engineering, have their benefits, so it seems. Since 2002, software sales have deceptively amplified the GDP. The practice even extends to car spending, since the likes of anti-lock brakes, cruise control, and elevated brake lights add to the overall quality of the car. Since we get more for the same car price, we must treat it as though we spend more. What is next, hedonic multipliers levering upward telephone call spending since fiberoptic lines connect states and continents? How about levering upward retail sales due to speedier cash registers, tied neatly to inventory systems? Let us not overlook self-service for gasoline pumps, grocery stores, and highway toll payment. What great opportunity for future hedonic lifts to distort the GDP and stated economic growth. If digital video recording aids in planned home television viewing, perhaps they can find a way to distort “down time” efficiency in the home. To the illiterate masses, who read nothing more than headlines, and comprehend nothing of mathematical formulas, GDP deception is an easy game perpetrated upon them.

Be sure to know that the same deception played upon economic growth is also played upon productivity. The basic formula for productivity is work output per unit labor expended. Any deception to output which benefits GDP also benefits productivity in like fashion. Hedonic lifts to productivity are a grand parallel distortion as well. At least half of the 1.9% productivity increase announced last week for Q3 of 2004 is probably total fantasy, maybe all of it.

EFFECT ON BOND YIELDS & ASSET PRICES

Wrongly reported CPI means that the bond market improperly delivers the deserved yield in interest rates to bond holders, which is warranted. They are cheated of a few percent in yield routinely, which would compensate them for capital erosion due to price inflation. Nobody in his or her right mind believes price inflation is in the 2% to 3% range. The reality is at least two times those figures. As a result, prevailing bond yields are kept too low by 2% to 3%, which bears immediately on stock valuation models. Hardly reported, the impact is low income returns for retirees, as their bond portfolio income is insufficient for their cost of living. Reports are rampant that the elderly are taking part-time jobs in response. Political power resides with active credit-hungry borrowers, not retired savers. If long-term bonds should be a few percent higher to offset price inflation, then the S&P stock index is perhaps 15% to 20% overvalued. The root of most amplified exaggerations in asset prices is improperly reported price inflation. Not only is economic growth distorted, but a wide array of asset prices are distorted as well.

Worse still, higher set longterm interest rates would spread to mortgage rates on home purchases and refinances. Higher mortgage rates would directly equate to higher monthly carrying costs for a purchased property, thus lower housing prices. The entire housing supply across the United States is perhaps also 15% to 20% overvalued from improperly set mortgage rates. Are Asian mortgage bond purchasers, who make up roughly one third of all mortgage finance funds, aware of the distortions? Many households who have very high loan-to-value mortgage balances might owe much more than the true value of their homes. If rates ratchet upward, we should see a movement toward appropriate value. In the process, many homeowners will be upside down on their loan balances, as loan balances exceed the collateral value. Don’t expect sudden moves to proper equitable rates and values. Price inflation will continue to be distorted low through under-reporting. Mortgage funds will continue to be made available, even if (as is probably done now) the Fed must monetize old Fanny Mae bond debts and sell new bonds which are equally loaded with leveraged risk. The USGovt works to overcome the overpricing in bonds via unapproved federal subsidies, which put the USDollar at great risk. This is a sham.

The most egregious violation is also perhaps the most obscure, the TIPS. Treasury Investment Protected Securities are intended to offer a yield to totally offset and neutralize existing price inflation, thus removing the risk. TIPS are often employed by analytic experts to judge the accepted and understood level of price inflation embedded into financial security prices. The retired and elderly typically migrate toward these supposedly safer instruments. Little reported, the elderly are the fastest growing segment filing for bankruptcy. Medical bills and spouse death (lost pension and SS benefits) are often cited, as well as assistance to their children in dealing with divorce, addiction, and lack of health insurance. As they stand now, TIPS offer half the yield they should. This is a sham.

SECTOR DISTORTION SUCH AS CONSUMER SPENDING

The last nasty consequence of misrepresenting price inflation, primarily in the PCE deflator, is that sector spending is then misreported. Since all the components must add up to the entire total GDP within the economy, each sector is also misreported and distorted higher. In particular focus is the consumer spending, the laughable faulty foundation of our economy, and the absurd premise of economic counsel. The same is true for durable goods spending and elsewhere. Our banking and economic leaders continue to promote poppycock principles, such as economic strength through final demand spending. Other analysts tear apart the numbers, and report a slowdown and actual reversal in consumer spending since Q4 of 2003, not a continued increase.

When a raft of retailers report a struggle to find any growth, believe them. Wherever we have conflict and disagreement between USGovt statistics and major retailers, trust the retailers and resist with strong doubt the official statistics spewed like propaganda to an unsuspecting and overly trusting public. The public desire for good news makes them gullible to distorted aggregate statistics. When disparity comes, the public tends to believe “it is lagging” and will catch up. Utter nonsense, and wishful thinking amidst ignorance. Consumer spending is likely flat now, possibly even going into decline, hardly what is reported. This is a sham.

CONCLUSION

In a Thanksgiving conversation with a retired Ohio banker, we debated in a sidebar over pumpkin pie the topic of premeditated deception. He was unwilling to grant that the USGovt harbored any motive to deceive, since we are an open society and the envy of the business world. Such blind naïve trust seemed more consistent with a child than a veteran Midwest banker. My claim was that managing the USDollar was a motive, to produce evidence that departed from reality of actual economic weakness. He laughed in my face at my claim that corporate profitability and productivity actually went into decline in the 1990 decade, despite technological breakthroughs. He mocked me openly, calling me naïve and gullible. He pointed to strong economic growth, without any awareness of the effect of under-stated price inflation. CPI was a joke in his eyes, but the consequent low-ball GDP was not accepted nor understood by him. He had zero knowledge that the post-bubble recovery was built on the back of massive debt growth by households and miniscule domestic purchases of capital equipment. Growing debt is typical, so he claimed, during the early recovery months as new equipment is put to work during expansion. He refused to see how outsourcing has bypassed the excess idle capacity inside the US Economy now. He did not distinguish between production cost inflation and general pricing power restoration, which he claimed. My counter-point that two types of inflation exist was laughed at. He harbored total doubt, even disgust, for my argument that games were played with job creation.

My other claim was that the USGovt is busy selling Treasury debt to foreigners, over 40% in fact, who must be convinced of our economic viability. He listened politely to my reasoning, that we as a nation could be honest if we sell our federal debt to ourselves, but not if we sell it to foreigners often hostile to us. He did not agree with me on any counts, yet admitted to having little information beyond major news media headlines. He gave me a firm warning, that the Wall Street Journal would have reported these many deceptions if they were indeed true. My reply was to check the WSJ advertisers and to think again. My parting shot, delivered with far more respect than was granted to me, was to watch the USDollar. If my viewpoint was correct, then the USDollar would suffer a long and painful decline, resulting in a crisis. At that time, the DXY dollar index was in the 90 to 92 range.

Make up your own mind. The government controlled national figures are laced with low-ball price inflation indexes, cluttered with questionable adjustments, entries from suspect statistical models, convenient seasonality corrections (or omissions), excessive but convenient stress of favorable components, and complete avoidance of relevant unfavorable components. The fraud has all the appearance of premeditation and systemic deception for the unexpressed purpose of financing our credit needs from abroad. The USGovt statistical apparatus has all the hallmarks of fraudulent Enron accounting.

NEWS TIDBITS

Microsoft agreed to pay $536 million in cash to settle an antitrust lawsuit tied to the Novell Netware network software, adding that Novell is also filing a new antitrust suit against Microsoft tied to their WordPerfect software. Microsoft also reached a deal with the Computer & Communications Industry Association (CCIA) under which the trade group agreed not to seek a review by the US Supreme Court in its challenge to a lower court final judgment in the USGovt antitrust case against Microsoft. Under the agreement, CCIA said it will not pursue its arguments in favor of the European Union antitrust suit against Microsoft, who is appealing the EU's ruling. Microsoft said it will pay the legal costs incurred by CCIA against Microsoft stretching back over 10 years. Rival media software maker Real Networks continues to seek charges against Microsoft stemming from anti-competitive practices surrounding Windows Media Player. Add Novell to the long list of successful litigants suing Microsoft, whose legacy of “innovation” requires a new entry in the standard dictionary.

Financial services regulator NASD has charged H&R Block Financial Advisors with fraud related to the sale of Enron bonds immediately preceding the Enron bankruptcy in 2001. The National Association of Securities Deals alleges that over a one-month period in late 2001, about 200 H&R Block brokers recommended and sold over $16 million worth of Enron bonds to more than 800 customers in about 40 states.

Bankers Trust Group will buy Infonet Services for $965 million in cash, giving the top UK fixed-line telecommunications company 1800 multinational corporate clients and an expanded presence in the United States and Asia. BT said the purchase of California-based Infonet, with a presence in 3000 cities across 180 countries, would allow it to manage more corporate IT and communications networks, particularly in the United States. Malaysian AirAsia is leaning toward European aircraft maker Airbus for an order of up to 80 short-haul planes, in what would be another blow to rival Boeing. News of the likely deal with Airbus that could be worth up to $5.2 billion came days after Air Berlin, Germany's second-biggest carrier, agreed to order 70 Airbus A320s worth as much as $4.5 billion with Austrian partner airline Niki. AirAsia, one of Asia's largest budget carriers, owns a fleet of jet aircraft currently made up entirely of Boeing planes. Delta Air Lines, the #3 US carrier, announced it will cut 2000 aircraft maintenance jobs, up to 3100 customer service jobs, and between 1600 and 1800 supervisory and administrative personnel as part of a previously announced plan to cut total staffing by 7000.

Oil prices dropped further from record highs as easing concern about winter supplies prompted large hedge funds to switch money away from oil and into other financial markets. Rising crude and natural gas stockpiles in the United States and signs that high energy costs are hurting economic growth have gradually eroded a rally that had lifted prices more than 50% this year. As confidence grows over supplies for the northern winter, speculative hedge funds cut their long positions in New York crude oil futures to the lowest levels in a year, according to the US Commodity Futures Trading Commission.

While the USDollar fell to a fresh record low against the euro, this time other markets are seeing fresh buying interest. Gold prices rose to a fresh 16-year high. The USDollar regained some minor ground against the euro currency after the head of the European Central Bank said the recent climb toward $1.30 in the euro against the dollar was "brutal" and unwelcome. ECB President Jean-Claude Trichet's comments on the euro, made after a meeting of central bankers in Basel, echoed comments he made in February when the euro hit a record high of $1.2927 at the time. The US currency, which has been in a tailspin since the re-election of President Bush for a second term in the White House, fell to a low of $1.2985 against the euro (EUR=) overnight in Asia and to multi-month lows against other currencies. Concerns are broad internationally over the unaddressed federal budget deficit and worsening trade gaps. The Federal Reserve meets to discuss a possible interest rate hike on Wednesday.

The last of the unbeaten fell in pro football, as the Pittsburgh Steelers delivered yet another defeat to a leading team, trouncing the Philadelphia Eagles. In movie box offices, “The Incredibles” led with a whopping $70.7 million in receipts, followed by “Ray” with $13.8M and “Grudge” with $13.5M.

TODAY’S MARKET

Today the Dow Jones Industrials rapped up at 10391 (+4), S&P at 1165 (-1.3), Nasdaq at 2039 (+0.3), TENS yield 4.215% (+2.9 bpt). Currencies closed with Euro at 129.15 (-0.31), JYen at 94.94 (+0.18), and the world’s strongest currency Can$ at 83.78 (+0.49). Metals finished with gold at 433.4 (-0.8), silver at 748.7 (-1.0), copper at 136.15 (+0.10). Energy ended with crude oil at 49.05 (-0.56), natural gas at 759.5 (-35.9), unleaded gasoline at 127.50 (-1.18). Prices are at major futures contracts.

Jim Willie CB

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