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Yet another way the government hides inflation
Contrarian Chronicles

http://moneycentral.msn.com/content/P73981.asp

The government may be the only institution that can say a price increase isn’t a price increase. Here’s how it masks the inflationary pressures building.

By Bill Fleckenstein

As we continue to shell out for higher prices, the Bureau of Labor Statistics is working overtime to crank out its inflation-is-tame data, picking from an arsenal of abracadabra. An inflation-busting device known as "substitution" is particularly effective (though for premium-brand ice cream lovers, as you'll soon see, it may be totally unpalatable).

The statistical minimization of inflation
I have long known that, in addition to hedonic adjustments (which I wrote about in "How the government manufactures low inflation"), government statisticians relied on "substitution." But until recently, I was unaware to what absurd degree. Their methodology is inaccurately labeled "geometric mean estimator," which it turns out is applied to about 61% of total CPI (consumer price index) spending. As my friend Joanie recently opined:

"Basically, this approach allows the BLS mathematicians to substitute lesser price items for those that might have had price increases. They assume, for example, that if tuna is pricey, you might just switch to cat food."

But don't trust us. Here, in the government's own words, is an example of the "geometric mean estimator" at work:

Substitution can take several forms corresponding to the types of item- and outlet-specific prices used to construct the basic indexes. . . . Thus, in response to an increase in the price charged by a store for a certain brand of ice cream, a consumer could respond by:

Redistributing purchases:
o To another brand of ice cream whose price had not risen.
o To a larger package of ice cream with a smaller price per ounce.
o To ice cream at a different store where ice cream is on sale.
o To a brand of frozen yogurt.

The consumer also could respond by postponing the ice cream purchase until a later date.

Finally, the consumer could substitute from the ice cream brand to a specific alternative dessert item, such as cupcakes or apples, which is another CPI category.

This latter form of substitution, although across CPI categories, would still have the effect of reducing the quantity consumed of the higher-priced ice cream brand relative to the quantities of other items within the ice cream stratum. . . . In the same way, the use of the geometric mean formula within categories does not address the issue of whether consumers can, or do, respond to a general increase in the price of ice cream products by, for example, forgoing dessert.
-- Quotes are from a BLS document, "Incorporating a geometric mean formula into the CPI." The emphasis is mine.

This is how the BLS keeps the CPI in check at all times. By using hedonics, price increases can be deemed quality improvements and therefore wiped away with the government's magic wand. If that doesn't work, the bureau uses the substitution technique to banish the price increase.

Pricier Kleenex nixes the 'no inflation' myth
In that spirit, the BLS will have no trouble wiping away -- though not with a Kleenex-brand tissue -- the prospective 6% price increase just announced by Kimberly-Clark (KMB, news, msgs). The maker of Kleenex said the increases were necessary to "offset inflation in key raw material inputs, particularly fiber, as well as higher energy costs."

This buttresses a point I have made before (most recently in my March 15 Contrarian column), that the high price of oil will work its way through to lots of different products, thereby increasing their prices, though that does tend to take some time.

Bottom line: The inflation statistics don't come close to capturing price increases accurately, and it's particularly absurd to strip out the offending components, as gets done every month.

As the government loses credibility on this subject, which I expect (the process takes time, but is almost impossible to repair), the erosion of confidence will impact financial markets bearishly and precious metals bullishly. It's part and parcel of the change in psychology that occurs in bear markets generically. And it is all the more likely in this bear market, given the insanity that's been perpetrated and perpetuated by the Fed and the statisticians in the government. That erosion of confidence will bring about a transformed environment, in which stocks bypass being "fair-valued" on the way to being downright cheap.