The Case for Hidden Inflation

05/28/2004 12:00 am EST

Focus:

Martin Weiss

Chairman, Weiss Research, Inc.

Regardless of one's bullish or bearish stance on the markets and the economy, all investors should read and consider the following strong words of caution from Martin Weiss, who says, "Hidden inflation is the seed for a big spike in interest rates."

"Ernest Hemingway once said, ‘The first panacea for a mismanaged nation is inflation of the currency. The second is a war. Both bring a temporary prosperity. Both bring a permanent ruin.’ These prescient words provide a not-so-subtle description of our plight today: Our currency has indeed been inflated—first with last year's dollar decline—and now with this year's surge in consumer price inflation. War expenditures, especially in the most recent quarter, have played a substantial role in the economy's growth. And both of these forces—inflation and war—are now coming together to help create a fleeting sense of prosperity, encouraging excess speculation in stocks, bonds, and real estate and giving rise to debt bubbles that are highly vulnerable to rising interest rates and creating the very pressures that will inevitably push those rates higher. The damage will not be permanent. But it could be severe.

"In an attempt to pooh-pooh this emerging crisis, economists have tried to focus your attention on the so-called 'core' inflation rate, which excludes energy. But it makes no sense. Energy cost increases have been consistent, persistent, and pervasive. And there is no good justification for excluding them from the analysis. Gas prices at the pump continue to surge. Overall,
the energy component of the Consumer Price Index (CPI) has ballooned by an annual rate of 38.6% in the first quarter.

"In addition, food prices are going bananas. Livestock prices have jumped a whopping 16% just in the first four months of this year. And that's despite the lingering fallout from the mad-cow-disease scare and the subsequent Japanese ban on US beef. Wholesale milk prices are through the roof, soaring to $18.10 per 100 pounds. Just one year ago, they were at only $11. The wholesale price per pound of cheese was $1.08 just one year ago. Now, it's at $2.02. Coffee is also going to cost you more and the price of a dozen Grade A large eggs just hit $1.33—the highest level in 23 years. So, when experts omit food and energy from the inflation statistics, I don't know whether to chuckle or clench my teeth. They just don't seem to grasp the tangible impact it's having on the average American's budget.

"The inevitable harbinger of higher consumer prices is the rising costs for raw materials. Now, shocking news just in from the Institute of Supply Management (ISM) shows that the prices paid by manufacturers for raw materials has hit its highest reading in 25 years. Among 38 materials prices measured by the index, 37 are rising. Meanwhile copper wiring has jumped by 80% in the last four months. Plywood has shot up by as much as 154%. And the price of scrap steel has soared 92% just since the end of last year. Until recently, American businesses were willing to absorb most of the rising materials costs and watch their profit margins shrink—but not any more. The March survey of National Association for Business Economics members showed that 32% are reporting an increase in selling prices, up from 29% in January. It's a classic example of cost-push inflation.

"Why is this not reflected in the CPI? The government has an agenda, which is to keep the CPI as low as possible. The reason? A difference of just a few tenths of a percent can translate into billions of extra costs for Social Security, federal pension costs, and a host of other outlays. How do they rig the numbers? Here are just a few of the gimmicks that have evolved over the years. For example, housing is 40% of the core CPI, and housing costs have skyrocketed. Ditto for home insurance rates and property taxes. So why doesn't the CPI reflect this dramatic change? Instead of using housing prices in the CPI, the government uses a substitute statistic called ‘homeowners equivalent rent’. They estimate what rent would be if a homeowner were renting their primary residence, and that's the figure they use for the CPI. As a result, the Bureau of Labor Statistics calculated the housing inflation rates from February 2003 and 2004 to be 0.2% in San Francisco. But anyone who lives there knows the increases are many times higher.

"The Bureau of Labor Statistics also has the authority to make subjective adjustments to the prices of goods to compensate for ‘improvements in quality.’ For example, from 1979 to 2003, the average price of a new car has risen 331%. But with its ‘quality adjustments,’ the government has chopped that down to 71%. The government applies this same type of inflation-busting process to more than 50% of the CPI components, including computers and appliances. Their logic is that you're getting more quality for your money. Also, when an item rises too quickly in price, the government can replace it with something that's cheaper or going down. For example, this year they removed sliced cheese from the CPI and replaced it with cheaper bulk cheese. But nothing was added to better reflect the rising cost of tuition, health insurance premiums, or gasoline prices.

"My advice? Don't underestimate the power of rising interest rates, and be sure to take all the necessary steps to protect yourself from the fall-out: In my opinion, the Fed must act to jack up rates sooner and more forcefully than Wall Street currently believes. You should reduce debt, build cash, and relax in the knowledge that you're fully prepared. And remember: No matter how dramatic the future market changes may be, it will not be the end of the world. When interest rates reach a new peak, you will be able to lock in rich rate yields for years to come. And when stocks hit rock bottom, you'll be able to pick up the bargains of a lifetime."

Editor's Note: At The Las Vegas Money Show, Martin Weiss announced the relaunch of his father's Sound Dollar Committee, the non-profit advocacy organization that helped President Eisenhower balance the federal budget more than 45 years ago. He began his workshop by making his own $50,000 donation to the group. For more info, visit http://ga1.org/campaign/sounddollarcommittee/

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