US GDP grew at an anemic pace in the second quarter. The "official" growth rate was 1.2%, well short of the expected 2.6% rate, and the number looks even worse when you consider it on top of the 0.8% growth rate from the first quarter (which was revised down from 1.1%). GDP growth decelerated on a year-over-year basis (GDP in Q215 grew 1.6%), and the latest quarter marked the fourth consecutive quarter of sub-2% growth for the US economy. As bad as the numbers look on the surface, we believe they are even worse in reality. The inflation rate that the government uses to calculate real GDP is unreliable and understates the true cost of living. After properly taking inflation into account, the US economy looks even weaker.
The government has an incentive to produce low inflation data. Low inflation allows the central bank to justify its expansive monetary policy stance for longer durations and ease the mounting fiscal debt burden by generating inflation through quantitative easing. And, because many of the government's expenditures are linked to reported inflation, such as social security and entitlement programs, "low" inflation reduces the cost of these payments. There are a number of issues with the CPI, the figure that the government uses as a proxy for inflation. First, the CPI lacks transparency. The raw data used to calculate the CPI is not exposed to the public, and while we largely understand the methodology (the CPI is a basket of goods that supposedly represents the purchase decisions of consumers), the refusal to release official data is a red flag. Second, the CPI lacks consistency. The government has changed the way it measures inflation more than 20 times in the past thirty years. Consumer purchase habits do change, but they do so somewhat gradually. The lack of consistency undermines the comparability across periods, and gives statisticians leeway to conveniently include or exclude certain items to conjure up lower inflation figures. There are a couple of examples of how the CPI understates true inflation. First, if the price of one good rises and consumers substitute to another good as a result, that first good will be excluded from the index. Harmonic pricing is another example. This is the idea that, if the price of a certain product stays the same y/y but the quality improves (for example due to technological advancements or new features), inflation somehow decreases because customers are getting a better value for their money.
But perhaps the biggest drawback to the CPI is that it doesn't take into account monetary inflation and the impact of quantitative easing. The expansion of the money supply is the true definition of inflation, and the spike in asset prices (from homes to stocks and bonds) we have seen in recent years is largely a product of this inflation. With rising home "values" pricing many younger buyers out of the market, rents have skyrocketed. Not only are rents rising, so too are utilities, healthcare costs, and tuition. Quantitative easing impacts all of these costs, either directly or indirectly. These are major expenses that your average consumer has to make, but they are not accurately represented in the CPI. In 2013, for example, the government measure of inflation was 1.5%, compared to monetary inflation of 4.9%. Figures 1 and 2 show alternative measures of inflation that include the impact of monetary inflation and illustrate what inflation would be if the government didn't change its methodology. We believe they better reflect the true cost of living.
Figure 1: Adjusted Inflation vs. CPI 1980 - 2016
Figure 2: Adjusted Inflation vs. CPI 2002 - 2016
What does all this imply? First it means that wages aren't keeping up with the true cost of living, which is compromising the spending power of consumers. Second, it implies that, as weak as the reported GDP growth figures are, economic growth is worse in reality. Weak GDP growth also has implications for your investment portfolios. The Fed is unlikely to raise rates again this year, which should drive stock prices higher. The S&P 500 (NYSEARCA:SPY) sits at record highs, but it will likely edge higher during the next six months as investors switch from bonds to equities.
The latest GDP figures confirmed that the US economy is fundamentally weak. But after taking the true cost of living into account, the economy looks even weaker. This will not prevent stock prices from going higher however, as the Fed will refrain from raising interest rates this year.
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