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The FED's Deflation Smokescreen

Craig Harris
Harris Capital Management, Inc. CTA
September 18, 2003

In my daily communication to clients and newsletter subscribers at the beginning of the year, this is what I was saying:

"I guess what I'm saying is that I could envision a situation where prices are moving sharply higher as a result of the "print your way out of deflation" strategy while at the same time the economy continues to contract. So, the "nightmare scenario" of a deflationary collapse that the FED seems to be worried about is not my concern... my concern is an inflationary economic collapse which would give way to a global depression and then maybe a fiat currency collapse. Something that really hasn't happened exactly this way before."

I'd like to compare that statement to what I think is currently happening in the US and the world today, and where this worry about deflation is coming from.

First off, the Economist's commodity-price index, (the oldest in existence) is showing that the index as a whole has risen by 6% over the past 12 months in dollar terms, with the price of industrial commodities leading the way. the industrial component has risen by 17% over the same period, and non-food agricultural products have gone up by 21%. Platinum is up by 26%, copper 17% and nickel 40%."

Locally, the operating expenses from a homeowners association are a good proxy for the general cost of living because the expenses include things like insurance, gas, capital items, salaries, etc. Essentially everything except food is represented. In the past 4 years, for the same level of service, the actual expenses in my community have gone up over 40%. The Government says they should have gone up less than 10% if I use the CPI as a barometer.

Here is my general thesis. The government is tweaking (I'm being nice) the CPI. I'm not the only one that thinks so... back in June, the NY post published a story that quoted a BLS economist as saying "the widely reported numbers understate the rising cost of life from one year to the next. The fact is, he says, "more money is coming out of your pocket." He should know.

In case it's not obvious, there are many many motivations for the Government to understate the true rate of inflation. One important reason is how the nations GDP is calculated. When the government calculates the GDP, they take the amount by which they think the economy is expanding... then they subtract the rate of inflation. So, the key is in the rate of inflation, which is determined by the CPI. If the CPI is understated, growth is overstated. Many investors don't understand this important point.

The next motivation is that government expenditures are tightly coupled to the rate of inflation. Programs like Social Security and government wages are tied to increases in the cost of living. Some government bonds have their interest rates determined by the CPI. The bond market in general looks to the CPI as a factor in determining the "correct" interest long term rates using the equation interest rate=real return+risk premium+inflation rate. So... by understating inflation the government saves billions and billions of dollars. In this age of soaring deficits, understating inflation is an important tool for the Government to save money. Now... if it's true that the government is understating inflation, what will the result be? Well, one result is that the population will have less disposable income than they would be expected to have for those that believe the governments data. In other words, their costs of living are higher than expected and their wages are increasing at a rate below the actual cost of living increase. Another result would be long term interest rates lower than would be otherwise expected. The FED is using this and other potent tools in an attempt to hold long term interest rates low to stimulate a post bubble economy into a post bubble, new bubble economy. So why does the FED keep talking about the worry of deflation on the horizon? Well, if you were trying to restore a post bubble economy, and doing inflationary things like printing money at double digit rates, holding interest rates artificially low, suppressing the price of gold, and using every other inflationary tool you know how to use... would you talk about the danger of inflation? No, you wouldn't. You'd talk about deflation because if you talked about inflation, you'd kill the recovery you were trying to generate and put fear in the marketplace, driving up inflation in the process. Using a fiat money system, if you print enough money, you aren't going to have deflation so if they (the FED) really were worried about deflation that would actually imply that they don't understand what they are doing. I'll give them more credit than that.

In my mind, one of the most important things George Soros ever said was that "markets influence events they anticipate." That quote is worthy of a lot of thought. One reason is because Mr Greenspan has apparently adopted that as a mantra. In other words, if the market is worried about inflation, that worry will drive up prices because of the anticipation of inflation and then it will become a self fulfilling prophecy. If the market is worried about deflation, then that alone will suppress inflationary concerns and have an impact on the marketplace. As an example, for what I'll call the "run of the mill" investor, it he heard G say he was worried about inflation, then he might invest in gold, and that mentality might drive up the price of gold, which in turn would fuel inflationary expectations. So, this is all very important to understand. The people who take what the FED is telling you at face value are missing the point, and hopelessly naive regarding how the world works. I always chuckle when I see supposedly serious people taking what the FED says at face value. They tell you things designed to get you to think a certain way. Talk is one of the FED's most important tools in an age where his money has no intrinsic value and they rely solely on investor confidence to promote their warez... which in this case is fiat money coming out of a printing press for just the cost of electricity, paper and ink. They want to keep you invested in paper... because that's their realm... smoke, mirrors and money created by the stroke of a pen.

So... now you have your answer regarding why the FED is talking about deflation. It's a smokescreen to mask the truth, and the truth is that the actual cost of living is rising at a much greater rate than acknowledged, and that the "real" GDP is much lower than reported. I call that stagflation and I think that's where we are here today in September of 2003. I'm bullish on real things with intrinsic value and very bearish on the US dollar which in the interest of full disclosure I have been short for some time now. Also in the interest of full disclosure, I've been long gold from the 270 area and I'm still in the market. Gold is my insurance policy against a host of bad things that I believe are all within the realm of possibility.

September 18, 2003
Craig Harris
Harris Capital Management, Inc. CTA

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