Pimco bond fund manager Bill Gross writes a monthly essay that's essential reading for money managers. His October Investment Outlook argues that government statistics are a "con job": they under-estimate the current inflation rate by about 1% and over-estimate real GDP growth by 1%. According to Gross, this explains why consumers continue to borrow to fund spending (real incomes aren't growing), and why job creation has been so weak in this recovery (it's less of a recovery than you think). Here are two questions to ponder about this:
Question 1: Is Bill Gross correct that the inflation numbers are understated? Gross says that it's a mistake to focus on "core" inflation, which excludes food and energy. At the end of the day people have to buy food and drive to work, so stripping out sharp price rises in gas and milk is misleading. More important, Gross claims that "hedonic" adjustments to the CPI are a fraud. "Hedonic" adjustments are statisticians' attempt to capture improvements in quality. For example, say the price of PCs declined by 10% compared to last year, but now you get twice as much memory and a faster processor as well. A hedonic adjustment would book a price decline of, say, 25% rather than 10%.
Gross argues that hedonic adjustments to the CPI are a "con job", as they are applied to 46% of the weight of the US CPI with little justification. Hedonic adjustments depress CPI prices for most consumer durables, even including college textbooks.
Now, here's the question. Sure, in the short term hedonic adjustments can be abused and used to manipulate the CPI. But what's the alternative in the long run? Your standard of living is your income divided by the cost of goods and services you purchase. If the cost of goods and services falls and your income holds steady, your standard of living rises. Don't tell me that the radical improvement to the standard of living for almost the entire US population due to the invention and mass production of the washing machine is captured purely by the price decline of advertised products. People used to spend a day a week washing clothes by hand! The substitution effect due to innovation and product improvement has to be captured somewhere, and the CPI is the right place to do it. So if hedonic adjustments make sense in the long term but have little meaning in the short term, what's the solution?
Question 2: What are the investment implications if Gross is right and the CPI is understated and GDP overstated? Gross himself lists the following:
- Overvalued dollar? Foreigners would be less willing to hold US dollar assets if they knew the real growth numbers (or should I say "the real real growth numbers"?).
- Bonds a lousy deal? TIPS and Treasuries are a worse deal than they seem if the real inflation rate is higher than the CPI.
- Artificial benefit to the Government? Understating the CPI saves the Government money on index-linked benefits, and the value of its outstanding debt declines in real terms.
Here are three more investment implications I've come up with:
- Real estate a better deal? Real estate is a better investment than it seems, since higher inflation raises the value of real assets versus nominal assets.
- Mortgage-financed home equity relatively more attractive? Real mortgage rates are lower than they seem. (But real income growth is also lower, so housing affordability is unchanged for most people.) In fact, if buying bonds (ie. being a lender) is a worse deal than people realize, then being a borrower of any kind is a better deal than people realize. Perhaps that partially explains why the savings rate is so low...
- Tax efficiency more important? The real tax rate is higher than you realize. Any tax floors that are indexed are not being raised enough. So tax-efficient investing is even more important.
The whole issue requires more thought. If you think of other investment implications, or have insight into the core issue, leave a comment below.