Wednesday, October 13, 2004

A Federal Inflation Conspiracy?

Business Week Online
OCTOBER 12, 2004

By Amey Stone

A Federal Inflation Conspiracy?
Influential bond guru Bill Gross says the government is intentionally understating the CPI -- and what a howl that has raised
Pimco bond-fund manager Bill Gross has done it again. With his October investment outlook, titled "Haute Con Job," Gross has taken on the government's statisticians and Fed Chairman Alan Greenspan. He accuses them of purposefully underestimating inflation to make the economy look stronger than it is and keep Uncle Sam's costs artificially low.

In the two weeks since Gross's thesis appeared, critics have roared, government statisticians have laughed out loud, academics have expressed disbelief, and portfolio managers have scratched their heads. But everyone has read it. "It has been the talk of the market over the past couple of weeks," says Mike Englund, chief economist at research firm Action Economics and a frequent contributor to BusinessWeek Online.

Gross struck a nerve because he offers an explanation for what seems to be a growing point of confusion among the general public: Why are personal expenses rising so quickly when the government's consumer price index is rising at just 2% to 3% a year? The typical American household budget has seen major price hikes this year for health care, food, energy, and college tuition, points out Peter Cohan, a management consultant and author in Marlborough, Mass. "There is just no way the CPI is reflecting the actual increase in costs that the typical American family faces," he says. "It doesn't pass the smell test."

"RUNNING AMOK." Case in point: One restaurateur in Pennsylvania e-mailed BusinessWeek Online in response to a recent story citing tepid inflation statistics: "Being one who considers himself 'in the trenches,' what the heck is everyone (government, business publications) talking about inflation being kept in check? Talk to the folks down here to get the real deal. Inflation has been running amok for a year and a half."

According to Gross, the government is "fudging on inflation" by adjusting many of the prices that go into its calculation for improvements in quality (for example, a standard-issue corporate laptop computer has declined in price in the past five years, but it also has a lot more memory and capability overall). Gross also says the feds are adjusting for the fact that if the price of beef goes up, people eat more chicken. Therefore, it doesn't matter so much if a steak costs more. Economists call this phenomenon "substitution bias."

Due to these adjustments, Gross figures inflation is really about a percentage point higher and gross domestic product about a percentage point lower than official statistics. Such an error would have huge ramifications for government payouts due for Social Security or TIPS (inflation-protected bonds). It would also affect bond prices and interest rates. He calls the lower levels of official inflation "a con job foisted on an unwitting public by government officials."

OR IS IT OVERSTATED? For most economists and portfolio managers, however, Gross's arguments are pure heresy. David Kotok of Cumberland Advisors called the fund manager "unduly and extremely harsh," in an Oct. 1 e-mail to clients and leaped to the defense of government economists who "are highly skilled professionals who take their work very seriously" and "do not engage in governmental conspiratorial activities of the type Gross suggests."

Action Economics' Englund says academics have been studying this question for over a decade and have sophisticated research to back up the need for adjustments. "It is irrefutable that some adjustments have to be made for quality," he says, even if their size is open to healthy debate. Ironically, he says, much of the discussion before Gross's missive was that inflation is overstated and that the adjustments don't go far enough.

Right or wrong, Gross's argument has portfolio managers thinking, which could ultimately affect the market, even if the government doesn't change its methodology. Bob Sitko, lead portfolio manager for USAA Investment Management's private-account business, says one of his analysts brought the piece to his attention. "It's a tricky issue, and I don't feel equipped to adjudicate the issue [Gross is] raising," he says, but he believes Gross and others who have voiced this concern may generate some response from the Fed.

WRATH, RIDICULE, AND CREDIT. And Sitko says the debate has spurred him to do some deeper thinking about the way productivity increases in Corporate America have contributed to low inflation. He worries now that business reluctance to spend on new technology could suppress productivity growth and lead to more inflation in the future than would otherwise occur.

While Gross has raised wrath and even ridicule, he deserves credit for addressing head-on a central economic paradox that many ordinary folks are wondering about. The truth about the inflation number is probably somewhere between his claims and those of his critics, but based on the reaction Gross is getting, he's clearly asking the right question.

Stone is a senior writer for BusinessWeek Online in New York

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