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Economic and Market Commentary

Con Job Redux

Bloomberg’s John Berry and the Fed’s William Poole are well intentioned I’m sure but they have an agenda like we all do.

man hears what he wants to hear and disregards the rest.
                                                                              -Paul Simon

Bloomberg’s John Berry and the Fed’s William Poole are well intentioned I’m sure but they have an agenda like we all do. As I told a client last week, my agenda is to promote the interests of bond holders and by osmosis PIMCO’s and my own. Their agenda is to support the Federal Reserve, its strategies, and by osmosis the thinking of its chairman, Alan Greenspan. I was not surprised, therefore to read their criticism of my October Investment Outlook Haute Con Job, which called into question the validity of our government’s inflation numbers. Berry and Poole read what they wanted to read and, as Paul Simon once suggested, disregarded the rest.

My point, however, was as follows. The CPI inaccurately calculates Americans’ cost of living. Since Social Security and pension benefits, as well as the level of wage hikes are predicated upon the specific number and/or the perception of annual increases, Americans are being in effect conned by their government and falling behind the inflationary eight ball year after year. After slamming the concept of the core CPI, the primary culprits I cited were the government’s use of hedonic and substitution adjustments to lower the CPI by as much as 1% in recent years. John Berry, the columnist, claimed my report was “inaccurate and flawed.” William Poole, the Fed Governor, in effect said I didn’t know what I was talking about. I think they read what they wanted to read, and I would hope that they would hear what needs to be heard.

I did not dispute the fact that the quality of goods and even services can improve and that the government shouldn’t recognize that “hedonically.” I do disagree with those adjustments being reflected in a CPI that is used to calculate the benefits of wage earners and retirees. The U.S. government has over 40 different CPI indices – there is not one sacred calculation. There is a CPI for medical care for instance, and a CPI for services, as well as a CPI for transportation. Take your pick. But in using for retirement benefits an hedonically adjusted CPI that lowers annual price increases by as much as 1%, they take money unjustly out of Americans’ pockets. Peter Bernstein, in an article I cited in the Investment Outlook , suggested the same thing. He recommended the adoption of a new form of the CPI, which he dubbed the CPI/DX that excludes all durable goods prices – the items most subject to hedonic calculations. He wrote that “what people see and feel as inflation is what they pay for services and non-durables” not hedonically adjusted durable goods such as computers and DVDs.

I would take that assertion one step further by using the following example that strikes to the heart of the hedonic debate. Say the only product that Americans purchase and consume are bags of gumdrops – 100 to a bag that cost $1.00 per bag, with each citizen limited to 1 bag. Through the miracle of productivity, a way is found to fill each bag with 110 gumdrops that is now priced at $1.10. The government’s hedonic adjustments would now calculate that the bag really only costs $1.00 and that the CPI has not gone up. After all, each gumdrop in the bag still only costs a penny does it not? It does. But here’s the catch and the con. The price of a gumdrop hasn’t gone up, but the cost of a bag of gumdrops has. Because Americans must buy 1 bag as opposed to individual candies, their cost of living has increased by 10%. They must fork out an extra dime even though they’re getting more for their money. Now turn the gumdrops into computers, cell phones, refrigerators, etc. and you see my point. We can’t buy individual pieces of memory in a computer – we have to buy the entire package. And the package costs more whether it’s improved or not. The government’s hedonic adjustments may accurately reflect productivity increases, but they should not be part of a CPI, which is intended to depict America ’s cost to live. In effect, that allows the benefits of productivity to accrue to businesses (which don’t provide adequate raises) and government (which under-compensates Social Security recipients). Holders of TIPS who are hoping to keep up with the cost of living via their “inflation protection” are disadvantaged as well. It’s a con – pure and very, very simple.

William H. Gross
Managing Director


Past performance is no guarantee of future results. This article contains the current opinions of the manager and such opinions are subject to change without notice. This article has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Each sector of the bond market entails risk. Inflation-indexed bonds issued by the U.S. Government, also known as TIPS, are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation. Repayment upon maturity of the original principal as adjusted for inflation is guaranteed by the U.S. Government. Neither the current market value of inflation-indexed bonds nor the value a portfolio that invests in inflation-indexed bonds is guaranteed, and either or both may fluctuate.

No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC. ©2004, PIMCO.

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