Financial Sense Storm Watch Update "The Core Rate" by Jim Puplava 06/24/2005

A caller into a Washington D.C. talk show asked a very pertinent question regarding the business of living. “Have they changed the way they measure the rate of inflation? The CPI report in May was zero percent, excluding food and energy. If you take those things out, that is what is primarily driving up everything. What would be the real inflation rate, if you add back everything they take out?" The host of the show turned to his guest, a financial reporter from The New York Times. The host of the show and the Times reporter were caught flatfooted. The Times reporter couldn’t answer the question. The host then went on to say, "The inflation rate as it is reported has been quite low over the last few years. Next caller."

The caller to the show reflected the growing disconnect between Main Street, Washington and Wall Street. Each month consumers see their living costs go up—whether at the grocery store, the gas station, or at the end of the month when bills are paid. Personal income has stagnated, failing to keep pace with the rise in the cost of living. In the meantime the media keeps spinning any increase—whether it is booming real estate prices, rising gasoline prices, grocery bills, doctor and dentists bills or movie tickets—as nonevents. Prices keep going up. Wages keep falling further behind. It is a repeat of the staginflationary 70’s taxes and inflation. Inflation is on the rise and so are taxes. Property taxes go up each year, making it difficult for homeowners to hang on. The social security base rises each year making more of a worker's income subject to the tax. States are raising sales tax and auxiliary fees, while some states have raised income tax rates. Like many of the items of the CPI index, rising taxes never get counted.

In effect, what this caller was asking was how and when did they change the way they measure the rate of inflation? On a first hand basis he was experiencing inflation in his personal life with rising food and energy costs. There was a major disconnect between what he experienced in real life on a day-to-day basis and what he was told in published inflation reports. The host of the show and the financial reporter from the Times had no answers.

The caller was smart enough to know something changed and he was right. In the early 90’s the government realized it had a problem with rising entitlement costs for Social Security, Medicare, and government pensions. These entitlement payments were indexed by the inflation rate each year. With inflation on the rise it meant these costs were rising faster, thus making government deficits much worse. In order to bring the government deficits under control, it would be necessary to bring rising entitlement costs down.

One way to lower entitlements would be to bring the inflation rates down, which would translate into lower Cost of Living Adjustments (COLA). The way to do this was to bring down the rate of inflation. However, this was not done by natural means, but artificially through statistical manipulation. The supply of money and credit began to go parabolic in the 1990s as shown in the graph of M3. The rise in money and credit would mean higher inflation rates. Higher inflation rates would mean higher COLA adjustments, which would lead to bigger deficits.

The solution was to change the way inflation is measured. Media reports began to surface on how CPI was overstated. The real inflation rate was actually much lower according to government and Federal Reserve officials. The Senate Finance Committee appointed the Boskin Commission to study the problem and find a solution. The Boskin Commission published its final report ”Toward a More Accurate Measure of the Cost of Living,“ and submitted its findings to the Senate on December 4, 1996. The Boskin report recommended downward adjustments in the CPI of 1.1%. The CPI, which is used as the basis for COLAs to Social Security and government pensions, if lowered as recommended by the commission, would reduce future entitlement payments as well as impact other government programs. The CBO estimated that by overstating CPI by 1.1% it added $691 billion to the national debt by 2006. By then the annual deficit would rise anywhere from $148 billion to $200 billion annually by overstating the inflation rate. In effect the government was overpaying because the actual inflation rate was much lower.

The Boskin Commission recommended several changes to the CPI index which included:

The result of their implemented suggestions is the mish mash we have today, which bears no resemblance to reality. The Commissions recommendations had widespread support in the Clinton Administration, a Republican Congress and from financial luminaries such as Alan Greenspan, who was expanding the money supply at a very rapid rate as shown in the graph above.

Substitution
Up until the Boskin/Greenspan initiative surfaced the CPI was computed each month using a fixed basket of goods. That changed after the Boskin Commission. The Bureau of Labor Statistics (BLS) began using substitutions in their monthly computations of the CPI. If beef prices rose, it was assumed that people substituted chicken. If chicken prices rose, then consumers would switch to fish. If all these prices rose, well consumers would become vegetarians or maybe start eating Alpo.

Weighting
In addition to changing items in the index through the substitution principal the BLS also changed the weights of items in the index. Instead of straight arithmetic weightings the BLS began to use geometric weighting. The benefit of geometric weighting is that it automatically gave a lower weighting to those items in the CPI that were rising in price and higher weightings to items in the index that were falling in price.

As an example of how geometric weighting can produce lower values, a recent example from the 90’s bull market will illustrate the point through two Value Line Indexes. The indexes are essentially the same. They are made up of 1650 stocks. One index is arithmetically weighted and the other is geometrically weighted. Between January 1990 and December 2000, both indexes—which include the same stocks—produced totally different outcomes and returns. The geometric index peaked in April 1998. The arithmetic index did not reach its first peak until May 2001. The return from January 1990 to December 2000 was 52% versus over 300% for the arithmetic index. The geometric index peaked in 1998, while the arithmetic index did not reach its first peak until 2001. Since 2001 the arithmetic index has gone on to reach new a new high on 6/17/05, while the geometric index has never recovered from its peak in 1998. This is just one example how geometric weighting can produce lower outcomes not only in stock market indexes but also in inflation rates.

Hedonics
The manipulation didn’t stop there. The bureau also began to adjust prices for quality. This practice became known as hedonics. Hedonics adjusts the prices of goods as a result of the increased pleasure a consumer derives from a product. A few examples will illustrate how removed the index has moved away from reality. Tim LaFleur is a commodity specialist for televisions at the BLS. In December last year he adjusted the price of a 27-inch television set for quality improvements. The 27-inch television set had a retail cost of $329.99. However, he decided the new model, which still sold for $329.99, had a better screen. After putting this improvement through the governments complex hedonic adjustment model he determined the improvement in the picture was worth at least $135! Taking in this improvement he adjusted the price of the TV by $135, concluding that the price of the TV had actually fallen by 29%! [1] The price reflected in the CPI was not the actual retail store cost of $329.99, but $194.99. The only problem for we consumers is that if we went to Best Buy or Circuit City to buy that TV, we would still pay $329.99.

Another example of hedonics at work is the way the BLS treats rising automobile prices. Mr. Reese, a specialist for autos, took a 2005 model car, which went from $17,890 in 2004 to $18,490 in 2005. After adjusting for quality items and making antilock disc brakes standard, the bureau adjusted the actual $600 price increase down by $225. The problem for we consumers is that the price of the car in dealer showrooms was still $18,490.

The Substitution Effect
Substitution also plays a role in reducing the CPI. From 2001-2003 the CPI index fell by 1.6% reaching a low of 1.1%. Wall Street and the Fed were talking about the risk of deflation. Deflation was predicted everywhere in the press. The financial world became fixated over the risk of deflation even though the monetary presses were working overtime, credit was mushrooming, and asset bubbles were inflating in the mortgage, bond, and real estate markets. The reason for the decline was the substitution effect. Instead of using new car prices, which were going up each year, the BLS substituted used car prices, which were falling. In place of exploding real estate prices, the Bureau gave more weight to the price of rents, which were falling as more households bought homes. Rents were given more weight even though 69% of households own a home versus the 31% that rent.

What makes this look even more ridiculous is that in April the National Association of Realtors reported a year-over-year price increase in homes nationally of 15%.

One has to wonder as what kind of creativity will be used now that rents are starting to rise as apartment owners remove lease incentives. Perhaps the hedonic models will begin adjusting rising rents downward due to changes in the quality of amenities such as swimming pools, running water, magnificent views of the freeways, or the artistic effects of polluted air in creating colored sunsets.

Many homeowners may not be aware that as a homeowner they receive a fictional income referred to as Owner’s Equivalent Rent (OER). Essentially the BLS samples the price of rents in residential housing to come up with what a homeowner would receive hypothetically if they were to rent their own home. That sounds idiotic to me, since most homeowners would agree the family castle is in many cases a money pit and not a source of income. Unless the home is owned free and clear, most homeowners have cash outgo each month due to mortgage payments, property taxes, utilities, and repairs. As absurd as this concept appears, OER gets the largest weighting in the CPI index of 23% versus actual rent, which gets only a 6% weighting. OER is purely fictional, yet it carries the greatest weight within the CPI index.

Hedonics helps the BLS keep rising prices for goods in the CPI from ever showing up as rising prices. Even though the cost of housing, energy, food, medical bills, prescription drugs, tuition, and entertainment have soared, the government keeps reporting moderate inflation. Hedonics is partially responsible. It has become a convenient and subjective way of removing prices increases from the CPI. The combination of substitution, changing the weight of goods rising in price, hedonics and seasonal adjustments is one reason why the CPI and reported inflation has remained as subdued as it is reported each month. The problem is that these numbers are all fictional and bare no resemblance to what households face each month with their actual budgets.

Seasonal Adjustments
As if these distortions weren’t enough, there are the seasonal adjustments that remove the price increases that occur during certain times of the year, i.e. gasoline prices during the summer driving season or heating oil during the winter. Seasonal adjustments are nothing more than “intervention.” They are designed to remove or scale down volatility or price spikes. The only problem is that price spikes never show up in the CPI. Only price drops get recorded. Price spikes are statistically smoothed away so they never show up. Sharp spikes in oil, gasoline, heating oil, or food get statistically adjusted. This keeps the CPI low. It is why the caller at the beginning of this article was puzzled. What consumers see everyday in real life is so different than what the government reports and the markets accept each month. It is unreality TV.

Another way of understating the CPI is the “core rate," which is a nonsensical phrase that is commonly used in the financial world. Whenever the CPI rises, they back out food and energy to give us the core rate, which is much lower. Whenever the CPI rate goes lower, they refer to the CPI rate and not the core rate as they did this month. The CPI fell 0.1% in May from April. It was the first decline in 10 months. The drop was due to falling energy prices. Oil prices started out the month of May at $53.56 a barrel. They fell to $49.65 mid-month before rising back to $52.75 at the end of the month. Did the drop of $.81 really account for a drop in the CPI of 0.10%? If the CPI is as moderate as the Fed claims, then why are they raising interest rates? Could it be inflating asset bubbles, such as real estate, mortgages, and consumption, the imbalances in our trade deficit or expanding annual credit of $2.7 trillion? They haven’t really told us.

Finally, let’s clear up the other nonsensical notion of excluding energy. Energy is essential to industrial economies. It takes energy to extract raw materials from the earth. It then takes energy to manufacture the things we use and consume. It also takes energy to transport the goods we produce. Even the energy we consume takes energy to produce whether it is oil, natural gas, or electricity. Petroleum products contribute about 40% of the energy we use in the United States each year to other products that we never think about.

Transportation accounts for an estimated 67% of all petroleum use in this country. The rest is accounted for by nonfuel products and petrochemical and feedstocks. The list below from the EIA/DOE is not exhaustive, but is illustrative of the many uses of petroleum.

“Nonfuel use of petroleum is small compared with fuel use, but petroleum products account for about 89 percent of the Nation's total energy consumption for nonfuel uses. There are many nonfuel uses for petroleum, including various specialized products for use in the textile, metallurgical, electrical, and other industries. A partial list of nonfuel uses for petroleum includes:

• Solvents such as those used in paints, lacquers, and printing inks
• Lubricating oils and greases for automobile engines and other machinery
• Petroleum (or paraffin) wax used in candy making, packaging, candles, matches, and polishes
• Petrolatum (petroleum jelly) sometimes blended with paraffin wax in medical products and toiletries
• Asphalt used to pave roads and airfields, to surface canals and reservoirs, and to make roofing materials and floor coverings
• Petroleum coke used as a raw material for many carbon and graphite products, including furnace electrodes and liners, and the anodes used in the production of aluminum.
• Petroleum Feedstocks used as chemical feedstock derived from petroleum principally for the manufacture of chemicals, synthetic rubber, and a variety of plastics.

Petroleum feedstocks have been used in the commercial production of petrochemicals since the 1920's. Petrochemical feedstocks are converted to basic chemical building blocks and intermediates used to produce plastics, synthetic rubber, synthetic fibers, drugs, and detergents. Naphtha, one of the basic feedstocks, is a liquid obtained from the refining of crude oil.

Petrochemical feedstocks also include products recovered from natural gas, and refinery gases (ethane, propane, and butane). Still other feedstocks include ethylene, propylene, normal- and iso-butylenes, butadiene, and aromatics such as benzene, toluene, and xylene. These feedstocks are produced by processing products such as ethane (separated from natural gas), distillates, naphthas, and heavier oils.

Industry data show that the chemical industry uses nearly 1.5 million barrels per day of natural gas liquids and liquefied refinery gases as petrochemical feedstocks and plant fuel. 10 Demand for textiles, explosives, elastomers, plastics, drugs, and synthetic rubber during World War II increased the petrochemical use of refinery gases. Gas byproducts from the production of gasoline are an important source of many feedstocks.[2]”

As shown above from the government's own energy information sheets, the use of petroleum is critical to our modern industrial way of life. Does it really make financial sense to remove it from an inflation gauge that is used to assess the cost of living? Think of what life may become without energy. We may soon find out, if peak oil is really here. With the price of energy at $60 a barrel, excluding its rise from the cost of living is as impractical as it is disingenuous.

The “core rate” is a fictional concept designed to sooth the financial markets and distract them from the reality of rising inflation. The core rate does not exist anywhere in our economy. It is a fictional concept designed to obfuscate inflation.

The next time you go to the grocery store and experience shock and awe as the checker rings up your shopping cart, ask him or her for the “core rate.” See what kind of look you get. For that matter, when it comes time to make your monthly mortgage payment, instead of making the payment, send a bill to your lender for “owners equivalent rent.” And the next time you pay your taxes in any form, whether income or property, hedonically adjust the bill for the lower quality of government service. If your tax bill went up, just use hedonics to adjust the bill downward. Ah, you might say, "This is impractical. Nobody can ever get away with that." You would be right, but perhaps it is a question we must now ask of government. Somebody should start questioning the reported inflation numbers as our caller did at the beginning of this article. Problems can only be solved when they are acknowledged first. Washington, we have a problem: it is inflation, not deflation.

What needs to be monitored next as the US economy falls into recession and perhaps depression is what happens to money and credit and the price of the dollar. If credit expands and if the Fed or foreign central banks print money to buy our bonds, where will the next asset bubble occur? As long as we live in a world of fiat currencies with no backing to any of the world’s currencies central banks are free to print as much money as they want. There is nothing to stop them from doing so. What we have seen in this new fiat world is that when money and credit expands rapidly there are always sectors that will inflate and others that will deflate. As the technology bubble deflated, three bubbles in bonds, mortgages and real estate took its place. During this time, while new assets bubbles were in the process of inflating as one asset bubble deflated, the CPI fell and was cut in half, giving sway to the argument of deflation. In reality, the only deflation that was taking place was at the BLS in its substitution and hedonic statistical models.

The deflationist’s argument that inflation only takes place during times of war and expanding government budgets isn’t necessarily true. War or expanding budgets aren’t necessary for inflation to occur. Prime examples are Latin America, more recently Argentina, Brazil, Turkey and Russia, as is the Weimar Republic. If deflation takes hold in the US, it won’t be as the deflationists now see it. It will be as result of the currency falling faster than the rise in nominal prices as it occurred in Weimar Germany.

Given the size of mortgage debt and the amount of leverage in our economy and financial system the Fed will not tighten rates in a significant way. The table listed below, taken from the current bond market and John Williams' real CPI, shows just how far behind current interest rates are from real inflation rates.

REAL NEGATIVE INTEREST RATES Real CPI 5.5%
Federal Funds	1 Yr T-Bill	2 Yr Note	5 Yr Note	10 Yr Note	30 Yr Bond
3.25%	3.48%	3.62%	3.73%	3.95%	4.25%
INFLATION DEFICIT
<2.25%>	<2.02%>	<1.89%>	<1.77%>	<1.55%>	<1.25%>

As the US debt burden increases with each passing month, the Fed has only one option, which will be to print money. Up until now foreign central banks have relieved the Fed of most of that burden. Foreign central banks have been doing most of the money printing in an effort to sterilize capital inflows into their countries and keep their currencies from appreciating.

This issue has become more serious than is commonly recognized. According to the latest Q1 2005 Z.1 “Flow of Funds” report first quarter non-financial debt expanded a record $2.411 trillion. As Doug Noland reports in his June 10^th Credit Bubble Bulletin, during the decade of the nineties non-financial debt expanded on average $700 billion annually. Blow-off credit creation is now more than three times the pace. [3]

The following table taken from the same Gillespie report shows just how much of our debt has been acquired by foreigners in the last decade. The Fed has had little need to monetize debt. Foreigners are doing the Fed’s dirty work.

FOREIGN HOLDINGS OF U.S. SECURITIES
Security	03/31/2005	12/31/2004	03/31/2004	12/31/1994
Treasuries	43.0%	42.5%	40.1%	18.3%
Agencies	13.2%	12.7%	11.2%	5.7%
Corp. Bonds	27.3%	26.6%	25.3%	13.4%
Corp. Equities	13.4%	13.0%	12.4%	7.0%
Source: Gillespie Research / Federal Reserve

In effect, the US is exporting its inflation and it will ultimately result in deflation in the rest of the world, which is heavily laden with overcapacity and hyperinflation in the US when foreigners no longer finance our deficits. That is when the end game of hyperinflating our way out of our debt bubble really begins. Unlike the gold standard, there are no self-correcting mechanisms in the global monetary system. The dollar or any other currency for that matter has no intrinsic value. All currencies are fiat and have no limit to the amount of its supply. There can be no dollar short position as some imply, because by its very nature the supply of dollars is unlimited as the above statistics illustrate.

The real risk is what happens when confidence in the dollar wanes as it must. Like the Weimar Republic, which had its currency accepted as a means of payment during the initial stages of inflation, the gig was up once foreigners realized the full extent of the mark’s depreciation. That is when they began disposing the mark and the hyperinflationary stage was set to unfold.

What we can say now is that the US is experiencing real inflation in the economy that is much higher than what is reported (6-8%). In addition to real inflation in the economy, the US has experienced hyperinflation in the financial economy—first in the stock market (the tech bubble between 1995-2000) and then in the mortgage, bond and real estate markets since 2000. If inflation continues to increase as I suspect in the real economy, I can guarantee you it will never show up in the CPI and PPI. Real inflation will be removed statistically through the magic of hedonics, geometric weighting, substitution, and seasonal adjustments.

This whole process of purposefully understating the real inflation rate also keeps real inflation artificially subdued. Think of all of the aspects of our economy that are tied to the CPI. Listed below are just a few examples:

Labor contract negotiations begin with CPI adjustments. Annual raises at companies are based on CPI changes. Think of how many workers fall further behind in their pay because of an understated CPI. How many landlords are cheated out of their just rents by understated inflation rates? How many retirees are robbed of real increases to their pensions as a result of underreported inflation? What would be the real rate of interest, if bond investors figured out that the real inflation rate was 6% and not 3% as reported by the BLS.

An understated CPI also overstates GDP by not removing the full inflationary impact of pricing from nominal numbers. It also overstates productivity by overstating the numerator part of the equation.

Any debate over deflation or inflation must begin with the truth. By habitually pointing to an understated CPI as proof that inflationary forces remain moderate is disingenuous at best and fraudulent at its worst. The truth is that we are experiencing real inflation rates of 6% in the real economy and hyperinflationary rates in the financial economy in bonds, mortgages, and real estate. When the next downturn comes, it will most assuredly alert investors to keep a sharp eye out for the next asset bubble to hyperinflate. Will it be stocks as occurred in the Weimar Republic, Japan and the US? Will it be hard assets such as gold, silver, and other hard commodities as has occurred throughout all of history when governments inflate?

What we have now is inflation. Forget the CPI, PPI, and the ”core rate.” These are all fraudulent inflation gauges designed to confuse and obfuscate the real inflation issue. There is no such thing as the “core rate.” The core rate doesn’t exist in the real world. Next time you see an increase at the grocery store, the gasoline station, your utility or cable bill, your children's tuition, your property taxes or your dentist's or doctor's bill, ask for the “core rate.” That is when you will be confronted by the reality of its fiction.

P.S. The inflation/deflation debate will be showcased on the FSN network with both sides making their case. Bob Prechter was the first guest, Dr. Marc Faber, and John Williams will be next in line.

P.P.S. A lengthy piece on hyperinflation will be written making its case after my summer sabbatical in August. Part II of "The Great Inflation” coming sometime in late September early October. The piece will be lengthily and may be published in four parts due to the length of its contents. I’ve got Mary worried, because it’s beginning to look like “War & Peace.”

P.P.P.S. As many are fond of making bold predictions, I’ll make a few here.

References
Special thanks for chart courtesy: Stockcharts.com, LevittBrothers.com, and GillespieResearch.com

[1] Aeppel, Timothy, "An Inflation Debate Brews Over Intangibles at the Mall," WSJ, May 9, 2005.
[2] Eia.doe.gov energy information sheets, March 2003.
[3] Noland, Doug, Credit Bubble Bulletin, PrudentBear.com, June 10, 2005, p.8.
[4] Gillespie, Doug, GillespieResearch.com, 6/22/05.


	Storm Watch Update THE CORE RATE by Jim Puplava www.financialsense.com June 24, 2005