A Federal U-Turn

Here’s a controversial essay. Gary Shilling explains why the CPI OVERSTATES inflation and why fears of future inflationary spikes are misplaced. His conclusion? The Fed will be cutting rates within months…

Until recently, a revival of inflation in the United States was a major concern for investors. The spotlight was on employment and consumer commodities, but the recent slump in payroll jobs convinced many that perhaps the inflation scare was overblown.

Now, even though inflation worries have receded, along with the consumer price index, can investors forget about inflation? Keep in mind that the price of gasoline leaped by more than 40% since December 2003 to its summer peak, and the price of milk – another frequently purchased item – has risen more than 10% in the past year.

The price spikes in these items – necessities for most households – have convinced many commentators that despite June’s soft patch, inflation in general is spiraling upward.

We disagree: Even if some prices have risen sharply, investors should not position themselves for inflation.

Inflation Worries: Ignoring the Big-Ticket Items

Here’s one reason why. Gasoline only accounts for 2.7% of consumer outlays, while milk accounts for even less, 0.2%.

This concentration on small purchases neglects the big price declines in big-ticket, infrequently purchased items. These items are often discretionary, and purchase can be postponed if price increases appear temporary – or delayed if further price drops are expected.

New and used vehicles are in this category; outlays for autos and parts account for 5.2% of consumer spending. Computers are another example and, adjusted for the rise in computing power, their cost to consumers has dropped spectacularly.

Despite the widespread belief that inflation is much higher than reported, the evidence is that the consumer price index is overstated. A congressional study found that the CPI is biased upward in four areas. First, since the index has fixed weights, it doesn’t account for the tendency to buy more of what’s cheap and less of what’s expensive.

Second, the group of retail stores sampled monthly in the survey of selling prices changes slowly over time. As a result, rapidly expanding discounters like Wal-Mart are underreported, while those stores selling at full price are overweighted.

Third, quality improvements are understated, meaning that prices are recorded as higher than they would be with proper adjustment. Computers are one example.

The fourth upward bias in the CPI results from the fixed- weight base period, currently 1982-1984. DVD players, wireless phones and lots of other new tech items didn’t exist 20 years ago, but now account for significant portions of consumer spending. And their prices have fallen dramatically, so the CPI is overstated, since it doesn’t include them.

This study estimated that the annual increase in the CPI was overstated by 1.1%. While some subsequent adjustments reduced the CPI by 0.2% per year, it still shows much more inflation than an unbiased measure would report.

In fact, the U.S. government has begun issuing chain- weighted CPI figures along with the 1982-1984 official numbers. The chained indexes correct for the substitution and new products problems and consistently show lower inflation rates, both for the total CPI and the core index that excludes food and energy.

Inflation Worries: The Rise in Inflation Fears

But inflationary fears are so deeply embedded in most Americans that even if they were able to set aside all of their convictions that inflation is being vastly underestimated, they would still believe that the Federal Reserve is oblivious to the threat and is even promoting it with rapid monetary expansion, especially since the beginning of 2003.

My problem with this, though, is that, besides the traditional monetary measures, there are numerous other measures of money, like credit cards, which many consumers use to buy everything from groceries to gasoline to clothing. In any event, the money supply in the past year has grown less than nominal GDP and has been far from inflationary.

Furthermore, global excess capacity should keep American business pricing power in check, and this, in turn, will maintain steady pressure on labor costs. In addition, the Wal-Marts of the world are another important factor in keeping inflation low as cost cutting and lower prices are made possible by productivity enhancement.

I see the rise in inflation fears as being one more brief uptick within the disinflationary trend of the past 23 years. And so far, the Federal Reserve apparently agrees. The central bank will probably raise its federal funds target rate at a moderate pace. We envision a quarter-point increase at each policy meeting until the end of the year.

And then, as concerns about inflation turn to renewed worries about deflation, the Federal Reserve will switch from raising to cutting interest rates.

How’s that for contrarian?


Gary Shilling
for The Daily Reckoning
August 25, 2004

"If I can’t take it with me, I’m not going!"

– Sign on wall in a New Mexico restaurant

All this miserable canoodling…

Day after day…hour after hour…

Year after year…until you finally, in a fit of reason, come to your senses, give it all up…and drop dead! After a lifetime of earning, saving, investing…you go on to your reward without a farthing in your pocket, leaving no forwarding address for your brokerage statements.

Yesterday, Damien, our part-time gardener, brought over presents – including a bottle of fine Bordeaux.

"Damien, we should be giving you presents…not you giving us presents," we said, thanking him.

"Well, I used to work for this guy near Chatellerault. An old guy who died a few years ago. I worked on his gardens, of course. But then he died, and I didn’t think much about him.

"But then they called me to a lawyer’s office in Chatellerault not long ago. I was afraid I was going to be arrested or something. But I came to find out the guy had left me his house! So I’m just celebrating a little…

"You’re not going to give up gardening, are you?"

"Nah…I’m not doing anything different. I already have a house…and I eat well. And I like to work. Besides, I can’t sleep…I only sleep four hours per night. That’s why I work two jobs…"

Damien bustles around our place from 6 a.m. until noon…then, he goes to work for the local road maintenance crew. Money seems to have no meaning for him.

"Wouldn’t you like to take a vacation?" we asked.

"They force me to take a vacation from my work [at the county], but I don’t want to go anywhere. I like it here…"

Meanwhile, from the Daily Mail comes more evidence that money cannot buy happiness, even at today’s EZ credit rates. A young girl won over $2 million in the UK’s National Lottery to become the eighth richest teenager in Britain. What came next for her was a series of pointless spending sprees…and brainless boyfriends…ending, according to yesterday’s report, about where it began – sitting in front of the television for long hours of the day, wondering what to do with herself.

Money seems to bring so little contentment we wonder why people spend so much time and effort trying to get it.

But this is just one of life’s many mysteries.

Another one that comes to our attention today is how the teetering, tottering, shumbling, shambling financial markets are finally going to get up off the couch and do something. The Dow, the dollar, gold – all have been tethered, like junkyard dogs. The Dow to 10,000…gold to $400…the dollar to $1.20 per euro. Each time they try a run for it, they get yanked back.

There’s been no meltdown, no melt-up…no breakdown…no breakout…no bear…no bull…

Nothing has happened for so long people have come to believe nothing will ever happen. There are now 9,000 hedge funds, many of them betting that they can continue to borrow short and lend long forever.

"I mean," Ken Fisher explained to us, "we thought the twin deficits were a trigger mechanism and that the carry trades would be wiped out. Now we know they were not. The dollar has not collapsed as people thought it would."

Warren Buffett, however, has bet $19 billion that the dollar will fall. But Warren has a quality that few hedge fund managers can afford: patience. The hedge fund manager must show decent results each quarter…Buffett can afford to wait. Sooner or later, the day will come when what must happen someday will happen. When that happens, Warren Buffett – if he is still alive – will get his reward.

Then, he can go to his Greater Reward like the rest of us – penniless.

But with a smile on his face.

In the meantime, here’s Eric with more news:


Eric Fry, reporting from the Happiest Place on Earth…

– Your New York editor engaged in a bit of masochism yesterday by treating his family to a day at Disneyland. After depositing $394 at the entrance for six tickets, your editor attempted to recoup his sizeable investment…he never had a chance.

– He could have spent one solid week in the park and never felt compensated for the price of admission. To the contrary, he experienced a kind of negative amortization…the longer he strolled around the park, the less he wanted to be there. The physical grounds at Disneyland were as antiseptic as usual, of course. But impeccable hygiene only takes you so far.

– Many of the most popular rides and attractions were closed for renovation. Those that were operating were as entertaining as always. But your New York editor simply could not escape the idea that he could have spent $394 much more creatively. "Who can afford to pay that kind of money?" he wondered to himself, as he wandered around a half-empty amusement park.

– Something is broken, dear reader. Thirty years ago, your New York editor visited a very different sort of Disneyland – a Disneyland that charged a nominal entrance fee and then sold individual tickets for its rides. (Remember the "E- ticket"?)

– Disneyland is still a very nice place…but it has become a very expensive very nice place…much like the New York Stock Exchange. Stocks are still treating investors well, but the price of admission seems a bit out of control.

– Stocks continue to command rich valuations, despite the fact that oil prices are nearing $50 a barrel, semiconductor companies are struggling to sell computer chips and Wal-Mart’s sales growth is grinding to a halt…Why should stocks continue to command rich valuations? Could it be that share prices have become so expensive that even falling oil prices won’t help them?

– Oil prices tumbled for a third consecutive day Tuesday, as the price of light crude for October delivery fell 84 cents, to $45.21 a barrel, yesterday. The gold price also retreated, falling $7.30, to $405.00 an ounce.

– Meanwhile, the stock market slumped for the second straight day, as the Dow Jones Industrial Average fell 26 points, to 10,099, and the Nasdaq dropped 2 points, to 1,837.

– Will stocks soon resume their winning ways? Unlikely, says one savvy investment professional known to your New York editor. To the contrary, the anonymous market seer predicts the stock exchange is about to become the unhappiest place on earth, as the Nasdaq tumbles about 40% from current levels.

– Hold on to your hats, Mouseketeers, the stock market might become a little dangerous.


Bill Bonner, back in France…

*** There is the "flim"…and there is the "flam."

The flim is just investors’ instinct to do the very worst thing at the very worst time. Ordinarily, investors have no interest in tech stocks, for example. That’s why tech stocks are usually cheap. As with mining stocks, investors know they are little more than a hole in the ground with a liar on top.

Occasionally the average investor will take an interest in tech or mining stocks – that is, after the stocks have made the papers and already become preposterously expensive. His interest peaks at the very moment when he can lose the most money in them.

But flim without flam is like Bonnie without Clyde…Democrats without Republicans – you need both of them to give the lumps a proper shellacking. Fortunately, there is the creative, innovative, profit-seeking spirit of Wall Street to offer investors ways to part company with their money.

Through no fault of his own, a man makes money – say by flipping houses in San Diego. The next thing you know, he is at a cocktail party bragging about the hedge fund he’s put his money in. It’s gone up 25% in the last 12 months, he tells his audience. Not knowing any better, the poor fellows around him want in too. None seem to realize that the hedge funds have no better ways of making money than the regular mutual funds…and no greater likelihood of making him rich than an ordinary common stock.

Less, even. For the more fashionable the hedges become, the more willing investors are to pay the flam – fees to the fund managers. What’s more, hedge funds tend to be in zero- sum transactions – bets for which there is a loser for every winner. Out of 9,000 hedge funds, some must be winners; others must be losers. Someone must take the other side of every trade. Over time, all must come out about even – minus the flam.

And hedge fund managers are no different from other investors – only better paid. They get caught up in whatever delusion is popular…and sucked into whatever trade has the most potential to ruin them. Currently, it is the belief that they can take advantage of the Fed’s negative borrowing rates – while lending their own money long at higher ones. As long as nothing happens, they look like geniuses. But somehow, sometime something always comes along to blow them up. We wait to find out what.

*** Everybody’s talking about a bubble in real estate. But "Can you really have a bubble when everyone worries about one?" asked Ken Fisher.

Residential property in the United States has risen 50% – or $6 trillion – in the last five years. This is one of the fastest rates of increase ever recorded.

What’s next? Prices could flatten out. They could go down. Or they could go up.

We don’t know. Buying real estate on the basis of national trends is a little like getting married because Congress lowers tax rates for married couples. The real issues are in the details – what woman, when, how?

What property? At what price? Where?

Our advice: Forget the big picture. Only buy investments…or get married…when the object of your desires is irresistible.

The Daily Reckoning