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Posted 10/4/2004
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The government's inflation con job
They tell us prices are under control and 'prove' it with cynical manipulation of data. Thats why fixed-income investments like bonds offer little value.
By Bill Fleckenstein
In the nearly eight years since I began writing my daily column, I have been rather vocal on the subject of fun with numbers, both corporate and governmental. With a couple of little tricks at its disposal, the government has made a practice of understating inflation, and by extension, overstating GDP and productivity. I have also discussed this many times in the Contrarian Chronicles, most recently in "Yet another way the government hides inflation" and "How the government manufactures low inflation."
Despite the fact that there are potentially damaging consequences to this statistical manipulation, it has attracted little attention and aroused scant outcry. That may change prospectively, thanks to the publication last week of an important article titled "Haute Con Job," written by someone considered the country's foremost authority on bonds, Pimco's high-profile portfolio manager, Bill Gross.
Given Gross stature and widespread audience, perhaps the story will get some legs. If so, this thought process is negative for fixed income, negative for the dollar and bullish for the metals, as a crisis of confidence undermines the credibility of all the government data distorted by these machinations.
A mini-oeuvre on numerical maneuver
I am going to quote liberally from Gross' article, starting with his conclusions, just so you'll know from the outset where he comes down on these subjects. (Here's the link if you want to print it out and read it yourself.)
"The CPI as calculated may not be a conspiracy, but it's definitely a con job foisted on an unwitting public by government officials who choose to look the other way or who convince themselves that they are fostering some logical adjustment in a New Age Economy dependent on the markets and not the marketplace for its survival. If the CPI is so low and therefore real wages in the black, tell me why U.S. consumers are resorting to hundreds of billions in home equity takeouts to keep consumption above the line. If real GDP growth is so high, tell me why this economy hasnt created any jobs over the past four years.
"High productivity? Nonsense, in part -- statistical, hedonically created nonsense. My sense is that the CPI is really 1% higher than official figures and that real GDP is 1% less."
Gross backs up his 1% estimate with some work his firm has done. I wouldn't be surprised to find out that it's even higher, though there's really no way to know for sure.
Rotten-to-the-core inflation
Next, before hacking away at the hedonic and substitution fiddles used by the government, Gross pops off about the whole nonsense of core inflation -- which is, of course, another subject near and dear to my heart and completely and totally absurd -- because it strips out food and energy, two things that everybody must have:
"(There's a) con job perpetually foisted on the American public about the low level of inflation. 'Inflation under control' -- (ex food and energy, of course) shout the carnival barkers. 'The CORE is running at just under 2%,' the barkers shout with glee because a low CORE number tells us that we can continue to run monetary policy with negative real interest rates and fiscal policy with $400 billion deficits. A low CORE number allows us to pretend that American productivity is the best in the world, that the dollar should be strong, and that the markets, by golly, are going up. No matter that a gallon of gasoline is over two bucks or that a half-gallon of milk will set you back $3.69; the CORE is under 2%."
Inflation ointment: Apply liberally to affected areas
But as you'll see, the core rate is not Gross' major beef. It's the nonsensical extremes to which hedonic adjustments have been taken, something that my good friend Jim Grant has written about on many occasions as well. Though the hedonic adjustments began as a way to turn computer horsepower into price reductions, they have since been applied to lots of other goods. As Gross notes:
"In 1998, the methodology was adopted for computers -- surely the biggest step backward in realistic inflation calculations. Since then, the BLS has expanded the concept to include audio equipment, video equipment, washers/dryers, DVDs, refrigerators and, of all things, college textbooks! Today, no less than 46% (my emphasis) of the weight of the U.S. CPI comes from products subject to hedonic adjustments," Gross wrote.
That's 46% and probably growing.
Speaking of college textbooks, I bumped into a young college student who mentioned that his new math book cost $175. (Having been a math major myself, I don't recall paying much over about $30 a book.) It would be interesting to know how one calculates that the book has become six times better. Meanwhile, Gross notes that if you were to strip out some of the hedonic magic since 1987, as his firm has done, the PCE (or personal consumption expenditures, which is Federal Reserve Chairman Alan Greenspan's favorite inflation statistic) would turn out to have been between 0.5% and 1.1% higher every year. Obviously, that number adds up over time.
Substitution is no substitute
Continuing, Gross tackles the government's other intellectually dishonest stratagem, namely, substitution: "In addition, when 'substitution bias' (a BLS maneuver that follows your preference for Chicken McNuggets vs. a Quarter Pounder) is eliminated, the gap gets even worse. For those of you sophisticated economists who feel the substitution bias is more than justified, chew on this for a second: If you substitute a pound of chicken for a pound of beef because it's cheaper, then switch back to beef later on because it came back down in price, the overall round trip which resulted in no ultimate substitution and no relative price change winds up reducing the stated PCE. Oh man, what a con."
Gross then discusses the motives behind the government's (and Greenspan's) reasons for believing these rather unbelievable numbers: "Deceptive hedonic/substitution adjustments also serve a government burdened not only with hundreds of billions of annual deficits as far as the eye can see, but laden with a demographically aging U.S. workforce rapidly approaching Social Security time. By fudging on inflation, they pay less, and the amount could cumulatively run into the hundreds of billions over the next few decades."
The con job that hurts many
Lastly, Gross points out who is penalized by this cheating: "They disserve, of course, all of those who receive Social Security, as well as other private pensioners dependent on an accurate accounting of prices paid. They disserve buyers and holders of TIPS -- inflation protected securities -- which adjust inadequately to a faulty and near fraudulently calculated CPI that one day could total billions of dollars per year for TIPS holders. And they disserve all owners of U.S. Treasury obligations -- including foreign central banks and institutions. . . ."
One of these days, the world is going to figure this out. There will be a run on the dollar, and at some point, Treasury yields will be affected. One of my favorite expressions (besides this: In a social democracy with a fiat currency, all roads lead to inflation.) is: We know the government is going to cheat us, via inflation. The only question is whether they offer us a rate of interest that compensates us for this cheating.
Bonds' warts
That's the reason I find fixed income unattractive. Bill Gross' arguments are the very same ones I have long made for why I don't like TIPS. Yes, maybe they're the best of a bad lot. But I would prefer not to buy longer-dated fixed income until such time as I thought I was being compensated for the risks.
That is not to say I would be willing to short fixed income. I wouldn't, because I think the upcoming economic weakness may benefit that market. However, I don't consider bonds a sound investment. For folks who need income, I would not want to own anything longer than just a few years, a position I have maintained for quite some time.
Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column on his Fleckensteincapital.com site. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money.
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