A Manufactured CPI, Other Perils and Gold

TORONTO (ResourceInvestor.com) -- It seems especially clear to gold bulls and contrarians that the global economy is close to a tipping point. Good times don't last forever, trees don't grow to heaven, and history has borne out that at some point the excesses of every prolonged economic growth cycle have to be purged.

There is mounting evidence that something is about to break with a deadly cocktail of potential disasters conspiring against the sort of Goldilocks economic growth we've enjoyed. To name a few: Peak Oil, the housing bubble, overloaded and tapped out US consumers deep in debt, a very shaky European economic situation/idea, the reality that at some point China may stumble, the possibility of a repeat of 9/11, and P/E ratios and investor complacency levels that are still way too high.

The big question however, and one hotly debated by the prognosticators and pundits is what form the downturn will take? There are calls for everything from deflation, to stagflation, to hyperinflation, to a return to the realities of a longer cycle in the form of a Kondratieff Winter.

One interesting viewpoint which has been highlighted again recently is that the Consumers Price Index conveniently does not reflect the rate of inflation we are all experiencing.

The CPI and Inflation

As a consumer, the fact that prices are going up on everything is undeniable yet according to the official numbers, US Core CPI is up only 2.2% over the last year. Jim Puplava, President of broker-dealer Puplava Securities and operator of the popular website Financialsense.com, and Bill Gross of the mammoth PIMCO bond funds have both been outspoken on this issue, and the government 'con job' being perpetrated on all and sundry.

A recent article by Puplava entitled The Core Rate illustrated in simple terms some of the ways that the numbers are being adjusted. Here is a sampling:

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 (1996). 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 principle 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 return from January 1990 to December 2000 for the geometric index was 52% versus over 300% for the arithmetic index."

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%! 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%. 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."

"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."

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."

All of this seems quite compelling, and equally disconcerting. It is hard to have much faith in the numbers when one begins to realize how they are crafted.

As Bill Gross points out in Haute Con Job "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."

Clearly in the past few years there has been inflation on a level far above that reported in what appears to be a manipulated CPI. It has been driven by, among other things, the vulgarization of the market in the form of cheap money and credit plans whose terms beggar belief. The consumer has essentially been allowed to buy homes and automobiles that they can't afford on the never-never, with no money down, greatly expanding the pool of demand and the price tag on nearly everything.

The question is, will interest rates rise resulting in a credit squeeze and will, in Jim Puplava's words "A national mortgage bailout bill be passed lengthening mortgage payments in an effort to forestall debt defaults (The 100-year mortgage is born.)" Or will the housing bubble slowly unwind itself resulting in falling prices for America's main source of savings, neutral or lower interest rates, and some form of deflation?

The Other Side of the Coin

Other market commentators are beginning to foresee the possibility of a deflationary recession more comparable to, but less severe than the Japanese situation in the 90's which continues to persist, and the Great depression, which was also deflationary.

In that vein, well-regarded investment analyst/manager Donald Coxe of BMO Harris Investment Management has recently altered recommended asset allocations to include long-duration bonds which would outperform substantially in a deflationary environment. (long bonds in Japan outperformed NASDAQ in the 90's and American long-duration bonds were among the best performing asset classes in the '30's)

Part of the argument is that the Chinese are exporting wage and goods deflation as the manufacturing base finds a new home, hollowing out the American Mid-west. Foreign Affairs recently reported that Wal-Mart alone is one of China's largest trading partners. In fact the company purchased $18 billion worth of goods from China in 2004 which made it China's eighth largest trading partner, even ahead of Canada.

Clearly, slowing growth and a faltering global economy could result in increasing unemployment and bankruptcies, housing foreclosures, etc. When combined with the high-debt levels of American consumers, and the concomitant lack of discretionary income, and one more negative - a fragile demography, it is certainly difficult to see a positive outcome from all of this, and it appears deflationary. The reality is that the housing situation is "a bubble in search of a pin", but seeing it reported on so often in the media, along with the re-pegging of the renminbi does tend to give one pause, and suggest that it will not happen just yet.

Either way, it appears imminent, and the question is whether it will be orderly, or chaotic - many suggest that the government will not let it get to that stage. Even as those who ponder such questions debate what sort of downturn the world is facing, the man on the street is completely unaware that the music is about to stop.

Gold

Only God is privy to which direction the next recession will take - but at the end of the day, inflation and deflation are the one in the same - destructors of wealth under different names.

Gold stands in the way of this and has proven time and again that it is a true store of value. As John Hathaway wrote recently "Capital flows into gold under one scenario only: when the lack of investment returns elsewhere, the desire for safety, and the ascendance of a risk-averse psychology at large converge." In other words, by a process of elimination.

Hathaway's conclusion is that no matter what disaster fells the global economy, "It will culminate in a grass roots mandate for sound money, and will be expressed as a dollar gold price well into the four digits." Inflation or deflation, it is prudent to have a meaningful portion of the yellow metal in your portfolio, because we may be closer to this sort of calamitous derivation than people realize.

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