Inflation: Comparing Apples to Oranges

Smoke & Mirrors Won't Pay Your Bills

By Tony Allison, April 2, 2007

Inflation is one of those issues that concerns people, but the normal reaction is a shrug of the shoulders, and shake of the head. It’s a problem that affects lives and futures, but most see it as a murky, complex subject beyond their control. And the media seems to think it’s “well under control,” even if our wallets argue otherwise.

For those who grew up in the 1950’s and 1960’s, the world was a different place. An average guy with a high school education could support a large family. His wife didn’t have to work. He could save for retirement. He could pay down, or even pay off his mortgage by retirement. According to the US Census Bureau, Department of Commerce, the average family income in 1950 was $3,300. But then the average cost of a loaf of bread was 14 cents. That wouldn’t pay the sales tax on a loaf of bread today.

These days you need two paychecks to support a family, usually with no more than one or two kids. Both parents need college degrees to get good jobs. They have little or no savings and their kids will be saddled with student debt if they go college. How can a middle class family be worse off today than 50 years ago with a booming economy, low interest rates and “minimal” inflation?

These are complex issues, and globalization and the exporting of a large portion of our manufacturing base play a role. But inflation has not gone away, and is not as “quiescent” as the Fed would like us to believe. In the early 1990’s, the government was watching inflation rise and adversely affect federal deficits and what it paid out in entitlements. To bring down the cost of entitlements, the inflation rate was adjusted lower, but not by cutting government spending, or raising interest rates. No, inflation was lowered simply by changing the way in which it is measured.

As shown in the charts below, the money supply (M3) was rising rapidly by the mid-1990’s. This was destined to lead to more inflation, higher COLA’s (Cost Of Living Adjustments) on entitlements and larger government deficits. The Senate Finance Committee appointed the Boskin Commission to find a solution in 1996.

The Boskin Commission recommended changes to the CPI index, including introducing substitution (and abandoning the true fixed-weight formula for CPI goods), reducing prices by quality (hedonic) adjustments, and changing the weighting of goods from an arithmetic to geometric system. The geometric weighting gave a lower weighting to items rising in price and a higher weighting to items falling in price.

The changes implemented from the Boskin Commission recommendations enabled the CPI index to drop by 1.1%. Voila! With the stroke of a pen, inflation was reduced, GDP was boosted, and the government was saving billions of dollars in entitlement costs due to lower COLA payments. Unfortunately, the retired senior citizens living on fixed incomes didn’t see their costs of living lowered. Since these changes were implemented in 1997, the “fixed basket” of goods no longer exists. The CPI basket is now slippery and subject to interpretation.

John Williams is an economic consultant, both to individuals and Fortune 500 companies. He has a B.A. in Economics and an MBA, both from Dartmouth. He has become a specialist in government economic reporting and writes about it on his website: shadowstats.com. In a recent interview with Jim Puplava, Williams made it clear that the government massages the numbers, and the trend toward “Pollyanna” statistics is not new.

“As long ago as the Kennedy Administration,” noted Williams, “the government believed people would rather hear good news, even if it’s false. Unemployment statistics were easy. First they created the �discouraged worker’ category and counted them separately. Then under Clinton, they quit counting them at all. Upwards of 5 million people were no longer unemployed. Both the Clinton and Bush Administrations have continued to tinker with �hedonic adjustments’ and other dubious offsets in the CPI to mask the real rate of inflation.”

Based on today’s numbers, Williams believes that the current inflation rate is approximately 10%, given the way inflation was measured prior to the 1990’s. Williams also reconstitutes M3 (the money supply), which the government no longer reports. “It’s growing 11% on a year over year basis.” Williams notes with dismay that Fed Chairman Bernanke is already planning to change the current CPI index to even more of a substitution basis, instead of a fixed-weight basis.

“The original intent of the CPI was to measure a constant standard of living,” said Williams. “They are moving toward a declining standard of living, where you substitute hamburger for steak in the CPI because steak is getting too expensive. The next (comparison) may go to dog food.”

Most regular readers of Financialsense.com are not surprised that inflation may be much greater than is reported. Unfortunately, many, many others are unaware of the pervasive nature of inflation and how this “invisible tax” is wreaking havoc with our economy, our retirements, and potentially our societal fabric.

You can’t get rid of inflation by changing how it’s calculated. And no nation in recorded history has ever been able to create prosperity by printing increasing amounts of its currency. Smoke and mirrors only buys time for elected officials to gain reelection and sweep the problem temporarily under the rug. However, more Americans are discovering their quality of life is in retreat. If the CPI is really 10% as John Williams believes, then those 4.5% Treasury Bond yields don’t look so good on a real return basis.

While the cost of many consumer goods has fallen over the last few decades, especially electronics, the cost of living has risen relentlessly. The easier availability of credit has helped many to survive, but ultimately the debt load becomes a burden that cannot continue.

Ignore the “Core Rate” of inflation (calculated by removing food and energy costs from the already understated CPI). Ignore the happy media chatter about inflation as a non-issue that is “under control.” Listen to your gut. Observe the rising costs in your everyday life. Observe the debt levels rapidly growing in every area of American life. How will this debt be paid? Will the government raise taxes on an aging population to pay the trillions in Social Security and Medicare liabilities? Slash government spending by 50% or more? Or will it perhaps print the money out of thin air, and keep speaking confidently about a Core Rate that’s really not a problem. Don’t let the sleight of hand of statistical manipulation lull you into a sense of complacency. Smoke, mirrors, hedonics and substitution won’t pay the light bill, the doctor bill, or your property tax.

Source: Bloomberg data

As you can see, rapid money supply growth is not limited to the US. In Europe, Canada, Australia, Russia, China, and Brazil among others, money supply is growing at double digit rates. As is obvious from the charts below, we've seen rising commodity prices. Now, we're starting to see rising labor rates. The rise of gold and commodities of all kinds the last 5 years is not reflecting the rise of global “wealth.” It is merely reflecting the deluge of global liquidity and the resulting inflation it is creating. Tangible assets provide a measure of protection against inflation, no matter how it is reported.

Don’t confuse apples with oranges and the Core Rate with reality. Those that are prepared for inflation and accept its inevitability can protect themselves and their purchasing power. They can even thrive by investing in inflation hedges ahead of the many who still believe that inflation went away in the early 1980’s, never to be seen again. No amount of hedonic adjustments and clever accounting will be able to keep inflation from making life harder for the American worker and those on a fixed income. For many families and seniors struggling to keep up with the rising costs of everyday life, inflation is already having a profound impact.

There are always silver linings to every storm cloud. In countless ways today’s economy is more dynamic, more flexible and provides many more opportunities than the world of the 1950’s. Technological progress will continue unabated. However significant inflation continues as well, and it continues to favor those who are aware of its existence and are able to profit from it.

“What you don’t know can’t hurt you” goes the old saying. When it comes to inflation, the old saying doesn’t apply.

Today’s Markets

The Dow Jones Industrials closed up 28 points at 12,382.30. The S&P 500 ended at 1424.55 up 3.69, while the Nasdaq was virtually flat, up just .62 of a point at 2422.26. The Dow was helped by Altria Group (MO), up 3.5% to 68.22 as it started trading separately from Kraft Foods (KFT), which was down 2.6% to 30.85.

With economic data playing an increasingly important role of late, investors were initially expecting an update on national manufacturing conditions to set a more definitive tone to Monday's action.

However, after the ISM Index failed to offer a positive surprise following Friday's strong Chicago PMI data, participants were left looking for other catalysts to get buying efforts back on track after stocks recently limped into the end of Q1. The S&P 500 and Nasdaq ended the quarter up just 0.2% and 0.3%, respectively, but the Dow fell 0.9%, logging its worst quarterly performance since Q2 of 2005.

Tony Allison

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