Lies, Damn Lies, and CPI Adam Hamilton June 16, 2000 3013 Words Benjamin Disraeli , the prime minister of the British Empire from 1874-1880, was reported by Mark Twain to have uttered this brilliant quote on statistical analysis: “There are three kinds of lies: lies, damn lies, and statistics.” Anyone who has worked with numbers knows they will confess to anything if one tortures them long enough. Outside of the furious action in the gold market this week, the release of the Consumer Price Index on Wednesday was a notable event. The numbers reported were benign, and the eternal equity bulls heralded the report as an excuse to genuflect before the alter of 100+ P/Es and perpetual prosperity and wealth for all. Although the market appears to believe the CPI is an acceptable indicator of inflation, it is becoming increasingly clear that more and more economists are questioning the veracity of the numbers reported by the BLS. For May, the Bureau of Labor Statistics, a group of not so covert operatives buried deep within the bowels of the Department of Labor, reported that US consumer prices rose a mere 1/10th of a percent after flatlining in April. The “core” CPI rate rose only 2/10th of a percent. The core CPI rate is defined as the CPI less food and energy costs. Each time some news organization mentions the core rate, I have to shake my head slowly back and forth in awe. Now what good is a CONSUMER inflation indicator without food and energy? I guess I am a prima donna, as I have always lived under the assumption that without food and energy, I am dead. As someone who eats several times a day, needs to drive, and enjoys sleeping in a climate controlled environment, I find it odd that increases in food and energy prices are not relevant enough to inflation to be considered “core”. It is great to know the BLS feels non-essentials like food and energy can be divorced from the core inflation rate, as maybe one won’t starve to death without food, and won’t freeze to death without energy. (Interestingly enough, Alan Greenspan in a Tuesday speech accused those who question the Labor Departments statistics as being “cynics”.) Enough of the cynical “core CPI” rant, and back to the CPI… Enter cognitive dissonance, which results from hearing information about reality that directly conflicts with our observations of the same reality. Here is a quote from a newswire about the May CPI on Wednesday, “US consumer prices rose less than expected in May as cheaper gasoline and clothing limited the effect of the biggest rise in food costs in more than 18 months…” Cheaper gasoline in May? Hmmm… This assertion is easy enough to test. On May 1, the wholesale price for unleaded gasoline was 81 cents per gallon. On May 31, a gallon of wholesale unleaded cost 98 cents, yielding a blistering 21% monthly increase! (Annualized, this is over 250%!) This week, unleaded gasoline traded at record levels of $1.08 per gallon. Granted, the CPI is a backward looking report and is not focused on wholesale numbers, but if “lower gasoline prices” fueled the benign number, should the stock market look at the data as anti-inflationary given the HUGE rise in the wholesale gasoline price in May? In addition to the rise in gas prices in May, the Journal of Commerce price index increased 4%, the CRB commodity index rose 5%, the Goldman Sachs Commodity Index (GSCI) jumped 11%, and crude oil surged 14%. Benign inflation? The increase in the price of oil is particularly important. Oil is the most important everyday commodity in the industrialized world. Every good we consume is transported via vehicles powered by various oil distillates. Some of the electricity we use is generated by oil powered burners. Oil, in a very real sense, is the lifeblood of our geographically dispersed and highly specialized economy. How has oil affected the CPI historically?

Oil has had a rather dramatic impact on the CPI in the past. In the 1970’s the slope of the CPI line increased dramatically. Unfortunately, when the oil price restabilized, the CPI continued its uptrend in steep annual increases. The BLS even fragmented the CPI, and created two new measures, the CPI sans energy and an energy-only component CPI. The blue line in the graph above represents the plain vanilla CPI. The yellow line represents the CPI with energy excluded, and the green line represents the CPI energy components. The CPI Energy closely tracks the price of oil, as seen above, but oscillates at a lesser magnitude than raw crude. Since the mid 1980s, amazingly enough, the “no energy” line has been climbing faster than the general CPI, indicating energy has had a net NEGATIVE influence on inflation recently. With oil not explaining the incredible upward trend in the CPI since the 1970s, where else can we turn for an explanation of the CPI? First, a look at the methodology of the calculations is in order. The Bureau of Labor Statistics uses a funky statistical technique coined “hedonic regression.” Daniel Webster’s namesake dictionary defines hedonic as “characterizing or pertaining to pleasure.” “Hedonic Calculus” is described as the “appraisal of possible alternative choices in terms of the amount of pleasure to be gained and pain to be avoided in each.” Basically, the BLS uses hedonic regression to try and quantify gains of quality in a particular good in order to offset gains in price. For instance, if a computer operated at 50mhz seven years ago, and 1000mhz today, the BLS would claim the price of the computer today reflects much higher quality, so the price must be adjusted downwards dramatically to account for quality. And how is quality measured? The BLS website (http://www.bls.gov/) has many essays that are dozens of pages in length on hedonic theory as applied to different items. A quick keyword search of “hedonic” on the site yielded over seventy documents. I chained myself to a chair, sat on my hands, taped my eyelids up, and forced myself to read several of these lengthy and detailed studies on quality adjustments of the critical US consumer staples of VCRs and camcorders. The studies were carefully documented and explained why actual prices of VCRs and camcorders should not be used in CPI calculations, but downward “quality-adjusted” prices should be used instead. The net result of all the hedonic information I looked at was to understate prices, sometimes dramatically. By using the mathematical equivalent of tea leaves and goat bones, the BLS statisticians have created a surreal new reality where the “true quality adjusted” price of different goods may be “computed.” This practice creates a huge disconnect with reality. The only real place to get good price information is in a free, unmanipulated market, which provides a price based on the current best expectations of millions of independent participants. By taking free market test data and obscuring it with arcane mathematics, the real price increases are filtered out. The BLS has also reported having a practice of weighting CPI components that are dropping in price more heavily than components that are rising in price. They justify this practice by claiming consumers will substitute lower priced goods for higher priced goods when the prices of the more expensive goods are rising. The hedonics mumbo-jumbo coupled with calculations designed to overweight items dropping in price yields highly suspect understated inflation numbers. If unleaded gasoline goes up in price, what does the American consumer substitute for the gas their automobiles need to function? Hydrogen? Hamsters under the hood? If general food prices increase, what does one eat instead of food? The increased weighting of negative price movements of critical consumer items is indefensible logically. On the hedonic quality adjustments, does surfing the web and sending e-mail give one more pleasure on a liquid cooled fire-breathing 1000mhz Pentium 3 then on a dusty, decrepit 486? For the vast majority of consumers, increases in “quality” of luxury items like computers and camcorders is not very relevant. For them, the critical issues are inflation in the prices of essential items they must purchase every week for their family, including fuel, food, utilities, and other indispensable staples for living. Speaking of indispensable staples, it is easy to test the government inflation numbers. All you have to do is go back and look at all of your family’s bills, including food, fuel, rent or mortgage, entertainment, etc. for May 1999. The year over year CPI claimed an increase of general price levels of only 3.1%. Were your expenses this year 3.1% greater than last year’s? Take a look at your financial reality and see if you believe the BS (er, BLS I mean, Freudian slip)… So why is the BLS playing games with the numbers? The best case scenario is they are simply so deep in their research of analyzing tree bark thickness that they are missing the macro changes in the forest that surrounds them. Worst case, they are willingly helping or else being intimidated into complying with a scheme to keep the American people and the stock market ignorant of the devastating effects of inflation in our economy. The particularly cynical should note that this is an election year, and a large increase in inflation or a large drop in the overpriced US equity markets could have profound implications for the contest in November. There are many massive financial incentives for the US government to attempt to under report inflation in the economy. High inflation causes payments to millions of government pensioners, social security recipients, and veterans to automatically increase due to cost of living adjustments. Each incremental 1/10% of reported inflation results in very large increases in the costs of the many social safety nets the government has woven since the days of Franklin Roosevelt. Increases in the costs of social programs will wipe out the claims of a “budget surplus” we have heard so much about. In addition, high inflation makes the US dollar less attractive as an investment opportunity for foreigners. Running a trade deficit requiring over $1b a day in foreign financing, the US desperately needs to ensure inflation doesn’t repel these foreign financiers. If inflation trends upwards, the Fed will be forced to raise interest rates to keep the real return of the dollar at acceptable levels. But, in a perverse flight of irony, if interest rates are raised further the vastly overvalued US equity markets could collapse. Further inflation leading to interest rate hikes terrifies US policymakers. Finally, increases in inflation will lead to a higher price of gold, the arch-nemesis and mortal enemy of the dollar. The Austrian school of thought on economics, maintaining a laissez faire pro-free market and pro-capitalism perspective, defines inflation as simply an increase in the money supply. When the money supply increases faster than the supply of goods and services money purchases, inflation is the result. The reason prices rise ultimately is because relatively more money is chasing relatively fewer goods and services, resulting in general price levels rising. Even anti-free market and pro-socialism economist John Maynard Keynes recognized the true causes of inflation. He said, “Lenin is said to have declared that the best way to destroy the Capitalistic System was to debauch the currency. . . Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million can diagnose." In historic times, before the reign of fiat currencies buttressed only by confidence and assigned value only by faith, gold and silver reigned as supreme monetary assets. Since the gold and silver supply grow very little annually, they make good monetary instruments that can’t easily be inflated. Without paper to inflate, currencies were debased by shaving coins (lowering the weight), mixing precious metals with base metals (base metals aren’t rare), and forcing the populace to accept these coins by regulatory fiat. Unfortunately for the greedy debasing governments, the populations usually perceived the evil and hoarded all their pure coins and used the debased coins in everyday commerce. This practice is known as Gresham’s Law, “Bad money drives good money out of circulation.” In modern times, debasing a currency has become much easier for a government to execute and much more difficult for a population to detect until it is too late. With the introduction of true fiat currencies, the last 300 years has probably seen more instances of high inflation and hyperinflation than all the rest of human history combined. With debasement as simple as making a phone call and firing up a printing press, and so many valuable projects vying for so little real money, the temptation has been irresistible for virtually every government. Irresponsible growth of the money supply, resulting in inflation, is in effect a massive hidden tax on a population. The governments can print money today for nothing, spend it today at its full value, and the population pays the price later as more dollars in circulation chase fewer goods and price levels rise. Inflation creates disincentives for saving which cause major societal debt problems, as inflation rewards debtors (can pay back debts in cheaper dollars) and punishes savers (as a hidden tax that annually vaporizes a portion of one’s wealth). Maintaining our perspective on monetary supply growth and resultant inflation, let’s take a look at the historical CPI vs. M1. M1 is the narrowest measure of money supply, and includes “types” of money that consumers are most likely to have and spend, including coins and currency held by the public, bank checking and savings accounts, and credit union balances.

As we can see, the correlation between cash available to consumers and inflation as measured by the CPI is astounding. The lines have risen in lockstep for over 41 years. The CPI rose at a compound annual rate of 2.7% from 1959-1971, and jumped to 5.2% from 1972-2000. The most notable feature of the graph besides the correlation is the discontinuity in the slopes of M1 and CPI that occurs in late 1971. Prior to 1972, M1 and CPI were relatively tame and growing slowly. After 1971, the slopes of both lines begin ramping steeply upward. What changed in 1971? On August 15, 1971, President Richard Nixon presided over one of the three most significant financial events in the history of our nation. (The other two were the creation of the Federal Reserve in 1913 and the outlawing and confiscation of gold in 1933.) On that fateful day, for the first time in the history of America, the last remaining link between the US dollar and gold was severed. Various western governments had conspired to keep gold, the ultimate inflation barometer, suppressed in the years leading up to 1971. If gold’s veto on fiat currencies could not be cast in the market, fewer people would realize the depth of the fiat currency inflation problems. With artificially cheap gold, however, global demand was so high that the efforts of the governments trying to maintain faith in fiat currencies were overwhelmed. Although US citizens had long lost this privilege, until that fateful day in 1971, foreign holders of dollars could still redeem their currency for gold if they desired. With cheap gold flying away from the US at unsustainable velocities, Nixon had no choice but to amputate the last vestige of the official link between gold and the dollar. A direct consequence of this action removed the incentives for the Federal Reserve to maintain discipline in the growth of fiat paper US dollars. Without the international threat of redemptions of inflated paper for gold, the growth in the money supply measures (M1, M2, M3, MZM) and resulting inflation rates leapt upwards, and they have never looked back. Eventually, as with every other government in history that has debased its currency, the problems of inflation will come home to roost in an unbelievable way. So what is real rate of inflation in the US? It probably approximates growth in total money supply, or M3. Since 1959, M3 has grown at a frightening compound annual rate of 7.9%, while the CPI has “only” indicated 4.4% compound annual inflation. The real per capita GDP, in the same period, grew at a compound annual rate of only 1.4%, indicating the annual growth in the broad money supply exceeded per capita GDP growth by an incredible 6.5% annually. More money chasing fewer goods equals inflation. With money supply growth far exceeding per capita GDP growth for over 40 years, inflation will get much, much worse before it gets better in the United States. As this month’s BLS results made crystal clear, the CPI is not a valid measure of inflation, but has devolved into a mathematical Frankenstein’s monster. Real inflation, by any measure, is much higher than official Labor Department statistics indicate. Sooner or later, general price levels will rise high enough so everyone will be able to see through the statistical smoke and mirrors the BLS has deployed. When that day comes, international faith in the US dollar will plummet like a meteor, and hundreds of billions of dollars will be dumped in the international currency markets in nanoseconds. The only investment that has always thrived in highly inflationary environments in the past is gold. Gold always retains its inherent, intrinsic value through all financial turbulence, and shines its brightest when the demons released from the Pandora’s Box of inflation are wreaking the most havoc. As we began with a quote about misleading statistics from a great statesman, we will end with lucid quotes on money from two great thinkers… “Paper money eventually returns to its intrinsic value ---- zero.” – Voltaire “You have to choose between trusting to the natural stability of gold and the natural stability of the honesty and intelligence of the members of the Government. And, with due respect for these gentlemen, I advise you, as long as the Capitalist system lasts, to vote for gold.” – George Bernard Shaw Adam Hamilton, CPA June 16, 2000