Our April 6 post entitled “Three Reasons to Scrap GDP” considered what’s wrong with drawing too many conclusions about the health of the economy based on this one highly fretted-over number. This week it’s the inflation indexes, PPI and CPI, that will be in the news, along with the tidily trimmed down “core” readings. And what, exactly, does “core” mean? Why, it means we don’t count food or energy prices, of course. So how and why did we start caring about a number that measures inflation by leaving out what at times (like now) are the most inflationary pieces? This and other inadequacies, inaccuracies, and distortions in U.S. government economic statistics are explained in an eye-opening article by political and economics writer and commentator Kevin Phillips.

In “Numbers Racket: Why the economy is worse than we know”, published in the May issue of Harper’s Magazine, Phillips surveys the many changes that politicians and bureaucrats in every administration since Kennedy’s have made to the way readings on U.S. economic health are compiled and reported, conveniently masking problems that the country was experiencing at the time. Phillips puts it this way:

Since the 1960s, Washington has been forced to gull its citizens and creditors by debasing official statistics…. The effect…has been to create a false sense of economic achievement and rectitude, allowing us to maintain artificially low interest rates, massive government borrowing, and a dangerous reliance on mortgage and financial debt even as real economic growth has been slower than claimed.

Economist John Williams, whose Shadow Government Statistics web site serves as one of Phillips’s main sources, has dubbed the phenomenon “Pollyanna Creep”. Whenever unemployment is too high, or GDP is too low, or inflation is snowballing, administrations rationalize tweaks that make it look like things really aren’t so bad.

The idea of “core” inflation was cooked up by Nixon-appointed Federal Reserve chairman Arthur Burns. Burns decided that food and energy prices - which…gee, whaddya know…were making inflation look awfully high in the 1970s - should be excluded from the new “core” number because of their “volatility”. As a result, the Bureau of Labor Statistics (BLS) last month, for example, was able to report that producer prices for finished goods “other than food and energy” rose just 2.4 percent between February 2007 and February 2008, even though overall prices had climbed 6.4 percent.

Subsequent administrations continued to tinker with inflation calculations, in ever more creative ways. In 1983, the BLS decided that “owner equivalent rent” was a better way to measure the housing-cost component of the Consumer Price Index, replacing the actual cost of owning a home with an estimate of what the house might cost to rent. In the 1990s, CPI calculations were reshaped to give more weight to services, retail and finance. More recently, CPI has undergone more bizarre adjustments: cheaper products are substituted for ones that have become less affordable (assuming that if you can’t afford New York strip steak, you’ll buy hamburger instead, and - what a relief - your cost of living hasn’t increased); likewise, goods and services that quickly go up in price are discounted on the assumption that people are using them less because they’re too expensive; and, perhaps strangest of all, certain cost numbers are reduced in order to reflect a supposed increase in value that comes from quality improvement. According to data from ShadowsStats.com, if all the changes since 1983 were undone, newspapers would be sporting banner headlines about 12% inflation, instead of one-column, below-the-fold items reporting 4% annual CPI growth.

Similarly, unemployment numbers have been sliced and diced and massaged and fudged - don’t even think about trying to figure out the business “birth/death model”, which sometimes is the source of all the reported “new” jobs, and more - to the point where real unemployment may be more than twice the official rate. GDP gets a boost from the birth/death model too (all those phantom jobs generate a lot of paychecks), not to mention all the other “imputed income” you get from, for example, the rent you don’t pay because you own the home you live in.

Phillips’s conclusion:

The real numbers, to most economically minded Americans, would be a face full of cold water. Based on the criteria in place a quarter century ago, today’s U.S. unemployment rate is somewhere between 9 percent and 12 percent; the inflation rate is as high as 7 or even 10 percent; economic growth since the recession of 2001 has been mediocre….

He is careful to note, however, that “both Democratic and Republican administrations had a hand in the abetting of political dishonesty, reckless debt, and a casino-like financial sector.” This latter phenomenon is why we like to side with the house - using iron condors to collect income from risk-takers when the odds are in our favor, instead of sitting at the blackjack table wondering if the next card will mean 21 or bust.

By the first half of 2006, before the Federal Reserve had even stopped raising interest rates, economists were beginning to recognize where things could very well be headed: monetary policy easing, forced by a slowing economy and tightening credit, would both put downward pressure on the dollar (which already had resumed its decline by the end of 2005) and cause yields on U.S. Treasury bonds to plummet. The inflation risk was obvious to any educated consumer watching the news, but what some economists and analysts were also starting to consider was the possibility of a U.S. dollar end-game - foreign governments and institutions unwinding their dollar investments. The majority of experts dismissed the idea, arguing that investors couldn’t shun the dollar, because they’d be shooting themselves in the foot by causing their huge dollar-denominated holdings to lose even more value.

Fast-forward to this week. Despite sporadic reports that China was cutting back investment of its foreign reserves in U.S. Treasuries and other dollar-denominated assets, the media had pretty much lost interest in the story and was keeping its myopic focus on the housing crisis, the credit crunch, and the Bear Stearns failure. Then on Wednesday, an article in the Financial Times confirmed that migration of foreign funds out of the dollar is real and spreading.

The Times reported that South Korea’s National Pension Service - the fifth largest pension fund in the world - “will no longer buy U.S. Treasuries because yields are too low.” The story quotes an NPS spokesperson:

“It is difficult to buy more US Treasuries because the portion of our Treasury investment is already too big and Treasury yields have fallen a lot,” said Kwag Dae-hwan, head of global investments at the NPS. “We need to diversify our portfolio away from US Treasuries and we find asset-backed securities and corporate debt more attractive because of wider credit spreads.”

This is a very big fund, but surely one institution in one country does not a trend make. True. But the very next day, another Financial Times story revealed that Chinese exporters are moving away from the dollar:

According to Alibaba.com, the online company that matches Chinese suppliers with international buyers, the vast majority of their almost 700,000 Chinese suppliers no longer use dollars to settle non-US transactions to minimise foreign exchange risk.

“They are moving to euros, pounds, Australian dollars or even quoting prices in renminbi,” David Wei, chief executive, told the Financial Times. Moreover, he added, prices quoted in dollars were now often valid for just seven days compared with the 30-60 days common previously.

And there also was this item from Bloomberg earlier in the week:

Asian Central Banks Look to Invest Reserves in Region

By Arijit Ghosh and Aloysius Unditu

March 24 (Bloomberg) — Central banks from 16 Asian nations may invest more of their $1 trillion of foreign reserves in the region’s debt as Federal Reserve interest-rate cuts reduce returns on U.S. assets.

“This is something that most of us, that are not yet investing in, will be looking at,” Bangko Sentral ng Pilipinas Governor Amando Tetangco said in a March 23 interview in Jakarta. There can be “some kind of shift” to Asian sovereign bonds, Central Bank of Sri Lanka Governor Ajith Nivard Cabraal said in a separate interview on March 22, after a weekend meeting of policy makers from the region.

What happens if this trend continues? A sell-off in U.S. Treasuries would cause market interest rates to rise, despite whatever the Federal Funds target rate may be. Rising interest rates would make it tough for the economy to start growing again. At that point, all those assurances we were given that the recession would be “short and shallow” would fly out the window.

You don’t have to be a grizzled value investor to agree with Warren Buffet’s two key rules of investing: “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.” Since we opened our first trade for March expiration, the S&P 500 index is down almost 100 points - that’s a loss of over 6.6% in a little over one month, and the index is now off 12% from it’s January open.

Continued weakness in the U.S. dollar means that the Euro zone now surpasses the United States as the world’s largest economy. Bear Stearns investors were baffled by what simply had to be an entire day’s worth of bad ticks on Friday. In this environment, playing good defense is as important as ever, and in light of the above, it should be sufficient for us to report, happily, that we didn’t lose money over the March expiration cycle. (In fact, our March trades averaged 8% return on capital risked.) But enough about us, let’s talk about the market. Read the rest of this entry »

Yes, it’s time for our list of predictions for 2008.

Economy. GDP growth in the United States will slow to 1.5%, prompting an annoying number of articles on the decline of the US and lots of analogies to the Roman Empire. The Fed will bring discount rates all the way down to a futile 4.25%, in an attempt to put out an economic grease fire with a fiscal bottle of Evian. Which, as everyone knows, spells “naive” backwards. Oil will pull back a bit before rocketing to $120/barrel, and inflation will remain as “contained” as it is now - which just means we will continue to pay $5.00 for a half gallon of organic milk in Manhattan. Jobs will decline, unemployment will rise, the trade deficit will increase, and nothing in particular will be done about it, since we have an exceedingly lame-duck administration in office and it is an election year.

Politics. Obama will win the Democratic nomination, and will tap either Richardson or a current unknown as VP. Obama will be the next President. Huckabee will be enough of a thorn in the early primaries to cause: a) Bloomberg to enter as an “independent” (read: the wannabe establishment candidate) and b) Romney to get the nomination as the actual Republican establishment pours cash into his campaign out of sheer panic. One of the worst presidencies in US history will draw to a close, and our long national nightmare will almost be over.

[UPDATE 1/6/08] After watching the debate last night, and chatting with some friends over brunch today, I have to change my VP pick: it’s obvious that Edwards is auditioning for the job, and it seems much more likely that Obama will pick him over anyone else.  Edwards has everything to gain by taking this route, since his policies are more revolutionary than those of any of the other major candidates - he’s young enough that waiting 8 years for another shot at the title isn’t a big deal, plus as VP of the Obama administration, he’d be the default candidate.

Society: An alarming number of US citizens will continue to believe that the planet Earth was created in 6 days, and science literacy in general will only get worse. True literacy - the sort that excludes instant messaging, Twitter, Facebook, Time magazine, and any media owned by Rupert Murdoch - will also decline. Public health will improve slightly as insurance companies and HMOs slightly expand benefits in order to stave off the inevitable and much-deserved onslaught coming their way in 2009. Soccer (”Football”) will not gain any increased popularity or market share in the US, despite the presence of David Beckham. Celebrity gossip will continue to substitute for actual news coverage in the corporate-owned media. ClearChannel and the RIAA will continue to be their own worst enemies. The writers strike in Hollywood will have an interesting impact on the film industry.

Trading: Almost forgot! Volatility will stay in the 20-25 range for most of the year. The next bear market will get off to a fantastic start, and long stock traders will have no place to hide - well, except for those ultrashort ETFs. All those Chinese grandmothers who used their life savings to open stock accounts on the Shenzhen and Shanghai exchanges will squint jealously at our ability to short stock and trade options. Retail investors will waste that ability by continuing to buy RIMM and BIDU calls naked. ISE will take more market share from the CBOE and human traders on the exchange floors will continue to dwindle. At some point CNBC will stop going down to the NYSE floor because of all the tumbleweed. Hedge fund growth will have peaked in 2007. Cramer will have peaked in 2007. ETF growth will peak in 2008, and “orphan” ETFs will become a real problem.

Condor Options will have to stop accepting new members completely at some point, as you guys are sucking up some real volume now and we don’t want to make our trades illiquid.

Abby Joseph Cohen will remain bullish.

Yes, after awhile John Hussman really starts sounding like a permabear. But when we seem to be teetering on the brink of recession, it’s increasingly tough to paint that as a fault. From his weekly market comment:

Pop Quiz

How much “liquidity” has the Federal Reserve “pumped” into the $12.7 trillion U.S. banking system since March 2007?

a) $1.2 trillion, which banks have used to firm up their balance sheets

b) $600 billion, which banks can now use to make new loans

c) $16 billion, all of which has been drawn out of the banking system as currency in circulation

If you answered c, move to the head of the class. Investors who answered a or b have not only been misled by analysts and media stories, but have no idea how irrelevant the Fed’s actions are likely to be, except on short-term market psychology. [link]

Looking at the bizarre melt-up we witnessed last week, the reaction earlier this fall to Bernanke’s testimony, and the buzz now making the rounds that we might get a 50bp cut (egads!), it’s pretty hard to argue: the Fed obviously still has an impact on short-term sentiment.

But doesn’t influencing short-term sentiment sort of pale in comparison to, you know, actually fighting inflation while protecting the soundness of our financial system?

P.S. Citigroup economist says that by June, interest rates will be a full point lower than where they are now.  Well, if we get 50bps shaved off now, and we see some more selling in February/March (remember this year?), that’s not actually a very bold prediction.