Tuesday, March 4, 2008

The CPI currently released by the government is worthless propaganda

Fractal Gold Report

By David Nichols

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How high can gold go in this bull market? I've discussed this topic previously, but it's worth another look as gold continues its inexorable rise to $1,000 per oz.

The answer may surprise you on the upside, as gold is still ridiculously cheap at the current $974.

For gold to be equivalent to the 1980 high of $850 -- in real, inflation-adjusted terms -- it would have to rise to $6,030 per oz. That is a 6-fold rise from the current price.

There are not many things changing hands at 16% of the inflation-adjusted price, but this is the current situation in gold. This is why the current bull market will send gold prices into the stratosphere, far beyond what even the wildest bulls are predicting now.

The Consumer Price Index (CPI) currently released by the government is worthless political propaganda, so we're not going to use it to calculate the true inflation rate. Instead we're going to use the method for calculating the CPI in place in 1980 -- the year of gold's high.

Since 1980, starting with the Reagan administration, changes have been creeping into the calculation of the CPI, mostly due to a nebulous concept known as "hedonic price theory". These methodology changes have been used by every administration since 1980, Democrats and Republicans alike. It's irresistible for those in power, because there are so many political benefits to under-reporting inflation. The foremost benefit is it gets the government out of paying true cost-of-living adjustments.

I won't veer off too far into economic theory -- it's not called the "dismal science" for nothing -- but it's important to understand hedonic adjustments, as this is what makes the current CPI such a farce. Essentially the government adjusts prices down to reflect increases in quality and utility. For example, many things -- computers, autos, washing machines, even refrigerators -- have a lot more features and enhancements now than they did 20 years ago. So these technological enhancements are factored by government statisticians into the calculation of the inflation rate.

In other words, since computers and washing machines have so many more features now, the government thinks the price should be adjusted down to reflect this increased utility. So the increase in price of most goods is not due to inflation, but to an ever greater array of features and enhancements.

Of course we still just use cars to get around, and washing machines to wash clothes, and refrigerators to keep food fresh. We're not really getting any more for our money, and if we are, they are just small increases in convenience.

But these hedonic adjustments give the government all sorts of room to massage the data to fit a political agenda. It's not a surprise to learn that Alan Greenspan was a big proponent of hedonic adjustments during his tenure at the Fed.

And thus, through economic sleight-of-hand, a good chunk of the actual inflation rate magically disappears from the reported CPI.

But economists and Fed-watchers are catching on. One economist in particular -- John Williams of Shadow Government Statistics --has taken the time to calculate a CPI using the methodology from 1980, prior to all these obviously political adjustments.

Nobody was complaining back in 1980 that the CPI was incorrect and dramatically over-stating inflation. It seems logical to adjust gold for inflation using the actual method in place in 1980, especially considering the political manipulation of this statistic over the last three decades.

If you use the 1980 methodology, the current annual rate of inflation is 11%. The things we buy cost 11% more this year than they did last year. That seems just about right, too, if you're an American consumer who has to live with this wallet-draining inflation in the real world. Nobody actually lives in the low-inflation fantasy world of politicians and statisticians.

Gold hit its all-time high on January 21, 1980, at $850. It took 27 years to get back to these levels, even in nominal terms. In January 2008, gold finally busted through to new highs and kept on going higher.

However, in inflation-adjusted terms, gold isn't even close to this 1980 high water mark, because the purchasing power of the dollar has collapsed over the past 27 years.

If you use the actual CPI (1980 methodology), the price of gold would have to hit $6,030 to equal the 1980 high of $850!

So a great case can be made that gold is one of the cheapest things you can buy right now. There aren't many things that would have to rise six-fold to just get back to its price from 27 years ago. Can you imagine buying a house at 1980 prices?

This massive and systematic under-reporting of inflation also explains the huge nominal price rise in lots of other commodities and tangible assets -- they are really just moving back towards balance after a long period of undervaluation.

This is why gold has the potential to go absolutely wild to the upside over the next five years. It's got some catching up to do.

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