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Jim Willie CB is the editor of the “HAT TRICK LETTER”

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One cannot blame any institution from wanting to present a brighter picture than reality, to paint a rosier description in order to impress, perhaps even to minimize or deny some elements of weakness. Ask any person being interviewed for a new job. Ask any applicant looking for a loan. Ask any man who has eyes and designs for a very lovely woman. The US Economy is portrayed as far healthier, far more vibrant, far more robust, in its growth and stability than is actually the case. The USGovt is in the business of selling US Treasury debt.

The list of doctored official governmentally produced statistics is so comprehensive that a far easier task is to produce a list of undoctored statistics. My view of durable goods orders and housing starts has been assured of accuracy, although so many games can be played with seasonal adjustments. We should do away with all adjustments, or else report the nominal number along with a percentage swing for typical seasonal behavior. It is much like permitting murder by euthanasia (not youth in Asia). If permitted, then dissidents and whistle blowers can easily slip through the gates and be routinely scheduled for processing, a quick short-circuited abrupt end of life. What is so troubling about the doctored statistics is that the practice is now engrained and institutionalized. Nobody even seeks out nominal figures. Most people seem to expect adjusted statistics, and might even demand some adjustment in order to make sense of them. Ripe are the opportunities for constant alteration with little justification even offered by way of asterisked footnotes. In the criminal world, an oft-used device is the singular event, like an accidental death or supposed suicide or drive-by shooting or large fire or damaging explosion, which could offer extensive cloud cover for the theft of documents and egregious malfeasance in fraud, of course blamed on the victim.

INADEQUATE ADJUSTMENT FOR PRICE INFLATION

The red herring in recent months is the rise in the price index seen for 1Q2005 at 3.3% announced at the end of April. What makes this noteworthy is that adjusted Q1 growth in Gross Domestic Product (GDP) was stated as 3.1%, less than the price index for the first time recent memory, going back to the 1980 decade. What a watershed event in GDP stats!!! So, of nominal economic growth (plain numbers, no adjustments for anything), more of that growth was attributable in Q1 to price inflation than to actual increase in commerce and business, as in sales of goods & services.

My analysis indicates US GDP real growth is between 1.5% and 2.5%, no more. We all regard the CPI as a joke stat, which misrepresents consumer prices as an indication of price inflation generally. Take a look at this! The wizards see fit to adjust nominal GDP by even less than the silly CPI. The unaltered GDP is pushed down, in an attempt to remove price inflation, by an amount even less than the under-stated CPI. Any lack of proper adjustment in nominal GDP is falsely labeled as real economic growth. In my view, most of it comes from inadequate adjustment of higher energy & material costs, even food costs. Ironically, we boast that the economy is strong enough to handle higher energy costs, but evidence of that strength to handle more burden is distorted growth from wrongful (favorable) adjustment of those same energy costs!!! Most economic growth comes from hedonics to information technology and improper removal of general cost increases. The most glaring obvious higher cost born by the public and business world is for energy costs. The 1Q2005 Personal Consumption Expenditures (PCE) index was up an annualized 2.54% which is below the price index of +3.3% announced. The PCE is also known as the GDP Deflator. Find a rationale for any claim that the economic price rises were up only 6.3% since the 1Q of 2002. You cannot. It is nonsense and pure deception. Our GDP growth is mostly exaggerated technology spending and price inflation!!! The chart below has been shown before, and is worth an update.

Data from the trade deficit and inventory levels suggest that the 3.1% growth in US gross domestic product for the first quarter will be revised upward. The March trade gap narrowed from $60.6 billion to $55.0 billion, to spark a US$ rally. Then came the US business inventories, meanwhile. They were up 0.4% in March, but below consensus. On one hand rising business inventories might reflect growing business confidence to restock their pipelines. On the other hand higher inventories could also mean that sales have dropped and stocks have started to accumulate.

HIGHER COSTS FILTER THROUGH THE ECONOMY

The trend from 2001, when the Federal Reserve embarked on their grand money giveaway, has been for the Producer Price Index (PPI) to have grown at a greater pace than the Consumer Price Index (CPI). This is not the good news reported, but rather a severe sign of stress. The catch phrase here is “cost push” for producers. In recent months, they might have been able to pass along more of their rising costs. However, the trend has been for the PPI to rise at roughly twice the pace of the CPI. The end result is that profit margins for producers are squeezed, when those employers have already been pressured by higher health care costs. The stock market rejoiced low core April CPI (excluding food & energy) of +0.0% rise. Given the +0.6% rise in the PPI for the same April month, and the core PPI of +0.3%, one must answer the tough question of what consequence comes from the difference in PPI over the CPI. Herein lies the producer squeeze. General Motors had its answer, or rather Standard & Poor had an answer pertaining to GM.

Another item somewhat overlooked by markets is the rise in PPI and its effect on GDP itself. Indicative of higher costs paid, improperly adjusted payments for goods in the intermediate markets seem systemically overlooked in the calculations of the GDP statistic. By focusing on the final demand, the US Gross Domestic Product (GDP) fails to properly adjust for higher material costs throughout the entire US Economy.

So in summary of basic Sherlock Holmes detection, we see the PPI rising rather sharply. The CPI (for consumers in urban centers who don’t eat or use energy) has been tame by comparison. But remarkably, the GDP (used to pound the table to proclaim strong growth) removes only a fraction of the price inflation easily observed. This again is nonsense and pure deception. Outside technology, our GDP growth is mostly price inflation!!!

The queer phenomenon of how our particular US version of monetary inflation and doctored measurement of price inflation is unique in the Western world. We in the USA have managed to spew new money into the system, and have the CPI reduced in the process. This strange effect was explained thoroughly in a past article “Inflation Pushes Down the CPI” in February.

As money pours into new home mortgages, housing prices rise and rents fall. As money pours into new cars, used car prices fall. As the USDollar has fallen, commodity, materials, and energy prices have risen, so as to cause economic distress, liquidations, bankruptcies, outsourcing, and reduced wages. Meanwhile the huge trade deficit with Asia has resulted in gargantuan inflow of low priced imported products. The collective effect is for lower consumer prices. One correction is warranted. In that article, my words said that used cars comprise 30% of the CPI weighting. It is actually about 12%, all tolled with used cars, rentals, and leased cars included. Again, notice how the GDP Deflator, used to remove price inflation from nominal figures, is even below the horrendously suppressed Consumer Price Index. The Deflator receives almost no attention whatsoever.

TAXATION WITH LOBBIED REPRESENTATION

The Treasury Dept (home of the IRS) has reported a 20% increase in payroll income tax withholdings, year over year. The IRS has taken in an added $45 billion in tax receipts. Just two weeks earlier, the US citizenry had to grapple with income tax payments, even as 3.5 million people were forced into Alternative Minimum Tax requirements. Last year in 2004, an unfortunate 2.9 million people were forced into AMT. It is estimated that an incredible 20 million people in April 2006 will be compelled to pay according to the AMT guidelines.

Some might regard the income tax rising trend as a sign of restored health in the expanding US Economy. The flipside interpretation is that the AMT has put households in a vise to squeeze them, many of them wealthy. At the same time corporations no longer benefit from tax breaks such as the favorable equipment depreciation schedules. One sage view was that it would be worrisome if the IRS tax stream had NOT improved markedly. With so many wealthy (and not so wealthy) US taxpayers set to run through an AMT meat grinder a year from now, the pressure is squarely on the US Congress for tax reform before next year’s calendar pages are turned over.

Higher tax bills combine with higher gasoline costs, reduced tax incentives, and reduced credit extended by households to make for a risky situation. The result has been air pockets in the economy. Whether those pockets are filled and absorbed, who knows? The fact remains that the US Economy is weaker than reported. Some evidence was seen with retail centers reporting lower weaker sales in April. The most notable weakness was from the discounters like Wal-Mart, where the lower income households tread and ring up purchases.

RISKS & IRONY OF FALSE CLAIMS OF STRENGTH

The risks that come from false claims of economic strength are many. If a man staggers in his walk from internal weakness, frailty (like with emphysema lungs), or structural problems (like with bad hips and knees), then any added burden like a heavy backpack or full military gear with flack jacket is likely to weigh him down unduly. He is at risk of falling or wheezing until he falls. The combination of higher systemic costs and income taxes combined in April to deliver a shock, only to be compounded by higher gasoline costs. The weight of the backpack is made more problematic by stiff headwinds of higher interest rates.

As the US Federal Reserve struggles to find and achieve neutrality, it must consider the false representation of US Economic strength. The real economy (where things are made, grown, and serviced) might be far weaker than we know, and the financial sector might be more teetering than we know. When pundits and experts proclaim neutrality in the Fed Funds interest rate target, they look to the CPI in an absurdly indefensible exercise. Past patterns of rate hikes might not offer an effective yardstick for rational decisions. In 1993 to 1995, the US Economy was nowhere nearly as vulnerable to Asian labor competition, nor anywhere nearly as dependent upon zero percent finance deals. My memory has no links to 0% deals for cars, furniture, home electronics, or home appliances over ten years ago.

Behind the scenes, the 8000 hedge funds ply their risky trade. Only two hedge fund failures have reached the news headlines, that being KL Financial out of West Palm Beach in Florida. How many other funds failed and did not make it to the media? My guess is hundreds, but unless fraud is charged and reports surfaced, we do not hear. Financial market vulnerability might be associated with hedge fund survival much more than we realize. The trouble with this murky center of risk management (or is it mismanagement?) is that that we hear of the problems and damage only after the damage is done. Regulatory oversight is missing.

ENERGY PRICES, CONSERVATION & GDP STATISTICS

Since the mid-1990 decade, the USA seems to have been walking in reverse in its sensible ways. Homes are larger despite higher air conditioning (electricity) and heating costs. Cars roll off the assembly lines at 45% in favor of inefficient guzzler Sport Utility Vehicles. Finally, dependence upon home equity to support lifestyle is prevalent. With rising gasoline costs, both sales and profits are down for SUV and Detroit coffers. Can anyone link the bond and financial distress of General Motors and Ford to its heavy reliance upon SUV sales? Profits are down 40% generally for that class of vehicle. Sales are down 40% for certain SUV models. The Hummer stands as the most grotesque example of wastefulness, not to mention its last place slot on reliability.

Ironically, any attempt to reduce energy consumption, whether nationally sponsored and promoted, or privately initiated, would reduce energy sales. Given that the GDP grossly fails to properly reduce the higher costs, calling it economic growth instead, any conservation program would result in a sharp decline in the GDP statistics. The lower crude oil price, the lower gasoline price at the pump, these will be reflected in greater purchasing power for consumers. Don’t expect any conservation programs to be announced or urged.

Moreover, the recent drop in the crude oil price, from a March $57 high to a current $48 per barrel, has been a welcome breath of fresh air to consumers and businesses. The hidden effect sure to be seen in Q2 GDP statistics is a softer quarter than perhaps expected. Why? Because much of our proclaimed economic growth is nothing but price inflation. The lower energy prices across the board, given the inept tracking and adjustments, will be seen as softer Gross Domestic Product quarterly final numbers in the second quarter. Without a doubt, what has helped promote false growth on the way up (for energy prices) will soften the growth on the way down.

Risks abound when increasing the cost of money (interest rates) even as other costs are still in an upward trend. Look for more GM and Ford stories, more corporate bond distress, in coming months as the US Fed tightens and hikes interest rates in its mindless silly “measured” fashion.

Our Fed Chairman has a proven track record of being a monetary drunk driver. The Fed defense of the USDollar (via rate hikes) is putting the entire US Economy at great risk, ironically from fallout coming from the financial sector (bonds, housing, hedge funds). It is far more fragile and susceptible to more rising costs, like that of money itself. When devices are used to deceive on robustness of growth, the entire system is put at risk. We may enjoy the higher stock prices from deceptive earnings. We may enjoy the higher bond principals from deceptive price inflation. But when pressure is put on a system whose resilience and strength is less than advertised, the potential for big problems is heightened. These potentials are regularly discussed in the Hat Trick Letter monthly issues. Political pushback from the banking circles will likely to enough to halt the Federal Reserve in endless measured 25-bpt interest rate hikes. If another inverted yield curve (3-mo TBill yield higher than 10-yr TNote yield) like that seen in spring 2000 will not stop the Fed tightening cycle, then the Fed itself needs to have forced mass resignations.