December 2006 Newsletter
DECEMBER 2006 EDITION - Jan. 2, 2007
JOHN WILLIAMS' SHADOW GOVERNMENT STATISTICS
Issue Number 26
January 2, 2007
__________
Recession Recognition Likely in 2007
Dollar Poised for 30% Plunge
Dollar, Debt Monetization and Oil Prices Boost Inflation Outlook
Gold Easily Could Top $1,000
Fed to Tighten in Dollar Defense?
Equities and Bonds to Suffer
Hyperinflationary Depression Likely by 2010
__________
OVERVIEW -- OPENING COMMENTS
The U.S. economy and financial markets face significant peril in 2007, with the dollar sitting on the brink of a major collapse. The positive 2006 U.S equity markets and reasonably tranquil credit markets belie the pending turmoil that already has been set in motion by a rapidly deepening inflationary recession and exacerbated by the de facto long-term insolvency of the U.S. government.
Financial concerns in the year ahead should become dominated by growing recognition of a severe structural recession that is beyond traditional remedies, high inflation against which the Fed will appear impotent, and a sharp loss in the foreign exchange value of the U.S. currency. In conjunction with the inflation woes, the dollar crisis will lead to significant loss in the greenback's global purchasing power.
This environment will not be a healthy one for equity and bond prices, as the dollar's weakness increasingly will mirror the flight of foreign capital and liquidity from the U.S. markets. On a financial-weighted basis, the dollar has the potential to lose more than 30% of it value. Gaining from these difficulties will be the precious metals, particularly gold, which has the potential easily to push above $1,000 per troy ounce in the year ahead. Enhancing the demand for that safe-haven metal likely will be continued deterioration in the U.S. and global political environment.
Ultimately, the current circumstance will evolve into a hyperinflationary depression. Although such is not likely until the end of the decade, that financial end game for the current markets will tend to come sooner rather than later and will break with surprising speed when it hits. As discussed below, this is not likely to be a deflationary depression.
What lies ahead for 2007 and 2008 will be severe enough and financially painful enough to affect the outcome of the 2008 presidential election. Historically, the concerns of the electorate have been dominated by pocketbook issues. Prior to gimmicked methodologies making the reporting disposable personal income worthless, that measure was an excellent predictor of presidential elections.
In every presidential race since 1908, in which consistent, real (inflation-adjusted) annual disposable income growth was above 3.3%, the incumbent party holding the White House won every time. When income growth was below 3.3%, the incumbent party lost every time. Again, with redefinitions to the national income accounts in the last two decades, a consistent measure of disposable income as reported by the government has disappeared, but odds are quite high that the numbers for 2008 would favor an incumbent loss, i.e. a victory for the Democrats. Where I always endeavor to keep my political persuasions separate from my analyses, for purposes of full disclosure, my background is as a conservative Republican with a libertarian bent.
What follows or coincides politically with a hyperinflationary depression offers a wide variety of possibilities, but the political status quo likely would not continue. Times would be financially painful enough to encourage the development of a third party that could move the Republicans or Democrats to third-party status in the 2012 election.
Recession Recognition Likely in 2007. The 2005 to 2008 recession is getting worse, and continues to be reflected in a number of key economic series, ranging from retail sales to the purchasing managers survey, which showed an outright decline in November manufacturing activity. The various employment indicators remain in deterioration, while payroll growth broadly remains statistically indistinguishable from contraction.
The U.S. economy is in a deepening and protracted recession that likely will endure through 2007 and into at least 2008. With recent economic history properly accounted for, this downturn is the second leg of a double-dip recession that began with the downturn in 2000. The economic contraction is structural in nature, driven by the loss of production jobs to offshore manufacturing facilities in recent decades.
The effect of this structural change is that most consumers are unable to sustain adequate income growth beyond the rate of inflation. The only way that personal consumption -- the dominant component of GDP -- can grow in such a circumstance is for the consumer to take on new debt or liquidate savings. Both those factors are short-lived and have reached untenable extremes.
The federal government and the Federal Reserve also are in untenable positions, with standard economic stimuli unavailable. From the standpoint of the federal government, traditional fiscal stimulus in the form of tax cuts or increased federal spending have reached their practical limits with the actual annual budget deficit running out of control at $4.6 trillion per year (see this month's Reporting/Market Focus).
From the Fed's standpoint, it can neither stimulate the economy nor contain inflation. Holding or lowering rates will do little to stimulate the structurally-impaired economy, and raising rates may become necessary in defense of the dollar. Similarly, raising rates will do little to contain a non-demand driven inflation, such as seen in the current circumstance that is so heavily affected by high oil prices.
Under such circumstance, this protracted inflationary recession is deepening with few, if any prospects of a looming turnaround. It is the worst of all worlds for the U.S. dollar and the domestic equity and credit markets.
Inflationary Pressures Will Mount. While annual CPI inflation began its rebound in November, official reporting still meaningfully understated the CPI level due to the continued overzealous counting of energy deflation that already had run its course. More in line with reality was a sharp monthly rebound in the PPI, as well as rising price indices in the both the manufacturing and non-manufacturing purchasing managers surveys.
Of some concern, annual M3 growth is accelerating, picking up to 10.8% in December from 10.4% in November. Such is enough to begin raising issues of inflationary pressures from excessive monetary growth.
Further, Although the U.S. dollar has seen only minor selling pressure, so far, a major sell-off looms, and with that also will come significant inflationary pressures.
By mid-year, annual CPI inflation once again will be pushing 5%, assuming no further sharp spikes in oil prices and no massive dollar sell-off. Oil and dollar problems would accelerate the rise in reported inflation and increase its scope in the year ahead.
Alternate Realities. This section regularly covers the Shadow Government Statistics (SGS) alternate measures of official CPI and GDP reporting. When a government economic measure does not match common public experience, it has little use outside of academia or the spin-doctoring rooms of the Fed and Wall Street.
Effects of gimmicked methodological changes have been removed from the official series so as to reflect more accurately the common public experience, as embodied by the post-World War II CPI and the pre-Reagan-Era GDP. The methodologies for the series are discussed in the August 2006 SGS.
GDP. The alternate third-quarter GDP growth reflects the "final" estimate revision, with many of the methodological gimmicks of recent decades removed. The alternate third-quarter inflation-adjusted annual (year-to-year) GDP growth rate is a decline of roughly 1.5% versus the official 3.0% gain.
[Note: Historical data on both the official and SGS-Alternate GDP series are available for download on the Alternate Data page of www.shadowstats.com.]
CPI. The gimmicked annual core inflation rates eased again, slightly, in November, as regular inflation reporting began to rebound. With high oil prices continuing to permeate broad economic activity, both core and regular inflation reporting annual should resume/continue their upside movements with the December data.
[Note: Historical data on both the official and SGS-Alternate CPI series are available for download on the Alternate Data page of www.shadowstats.com.]
Hyperinflationary versus Deflationary Depression
This is the first in a series of articles on the greatest threat facing the U.S. economy and financial markets, a hyperinflationary depression. The current SGS explores why the system faces hyperinflation instead of deflation. The January SGS will discuss how the crisis could break and explores approaches to preserving wealth and assets in the turbulent times ahead. The February SGS will discuss business operations in, and day-to-day living with, a hyperinflation.
Fire and Ice
Some say the world will end in fire,
Some say in ice.
From what I've tasted of desire
I hold with those who favor fire.
But if it had to perish twice,
I think I know enough of hate
To say that for destruction ice
Is also great
And would suffice.
-- Robert Frost
As to the fate of the developing U.S. great depression, it will encompass the fire of a hyperinflation, instead of the ice of deflation seen in the major U.S. depressions prior to World War II. What promises hyperinflation this time is the lack monetary discipline formerly imposed by the gold standard and a Federal Reserve dedicated to preventing a collapse in the money supply and the implosion of an extremely over-leveraged domestic financial system.
The differences between recession, depression and great depression are defined here, because meaningful definitions have not been published otherwise. Before World War II, all economic contractions were called depressions. A "recession" was the down-leg of a depression, and became a post-World War II euphemism for depression, when the economy contracted for at least two consecutive quarters. While no one involved in the GDP reporting or recession determination process has had to define what might be considered a "depression" since then, I have found common ground with other economists in defining the terms by the magnitude of economic contraction.
From peak to trough in the economic cycle, an inflation-adjusted decline in GDP of less than 10% is considered a recession. A decline of 10% or more is a depression, and a decline of 25% or more is a great depression. On that basis, there has been the one Great Depression. Most of the economic contractions before that were depressions. All business downturns since World War II -- as officially reported -- have been recessions.
Shown below are two graphs measuring the level of consumer prices since 1665 in the American Colonies and later the United States. We have published the first graph before. It shows what appears to be a fairly stable level of prices up to the founding of the Federal Reserve in 1913 and Franklin Roosevelt's abandoning of the gold standard in 1933. Then, inflation takes off in a manner not seen in the prior 250 years, and at an exponential rate when viewed using the SGS Alternate Measure of Consumer Prices in the last several decades. The price levels shown prior to 1913 were constructed by Robert Sahr of Oregon State University. Price levels since 1913 either are Bureau of Labor Statistics (BLS) or SGS based, as indicated.
The magnitude of the increase in price levels in the last 50 years, however, visually masks in the first graph the inflation volatility of the earlier years. That volatility becomes evident in the second graph, with inflation history shown only through 1960.
What is shown in the second graph is that up through the Great Depression, regular periods of inflation -- usually seen around wars -- have been offset by periods of deflation. Particular inflation spikes can be seen at the time of the American Revolution, the War of 1812, the Civil War, World War I and World War II.
The inflation peaks and the ensuing post-war depressions and deflationary periods tied to the War of 1812, the Civil War and World War I show close to 60-year cycles, which is part of the reason some economists and analysts have been expecting a deflationary depression in the current period. There is some reason behind 30- and 60-year financial and business cycles, as the average difference in generations in the U.S. is 30 years, going back to the 1600s. Accordingly, it seems to take two generations to forget and repeat the mistakes of one's grandparents. Similar reasoning accounts for other cycles that tend to run in multiples of 30 years.
Aside from minor average annual price level declines in 1944 and 1955, the United States has not seen a deflationary period in consumer prices since before World War II. The reason for this is the same as to why there has not been a formal depression since before World War II: the abandonment of the gold standard and recognition by the Federal Reserve of the impact of monetary policy on the economy.
The gold standard was a system that automatically imposed and maintained monetary discipline. Excesses in one period would be followed by a flight of gold from the system and a resulting contraction in the money supply, economic activity and prices.
Faced with the Great Depression, and unable to stimulate the economy partially due to the monetary discipline imposed by the gold standard, Franklin Roosevelt used those issues as an excuse to abandon gold and to adopt close to a fully fiat currency under the auspices of what I call the debt standard, where the government effectively could print and spend whatever money it wanted to.
Roosevelt's actions were against the backdrop of the banking system being in a state of collapse. The Fed stood by twiddling its thumbs as banks failed and the money supply imploded. A depression collapsed into the Great Depression, with intensified price deflation. Importantly, a sharp decline in broad money supply is a prerequisite to goods price deflation. Messrs Greenspan and Bernanke are students of the Great Depression period and, as Fed Chairmen, respectively vowed not to allow a repeat of the 1930s money supply collapse.
Where Franklin Roosevelt abandoned the gold standard and its financial discipline for the debt standard, eleven successive administrations have pushed the debt standard to the limits of its viability. This is particularly evident in the GAAP-based financial statements of the U.S. government, which show the actual federal deficit at $4.6 trillion for 2006 alone, up from $3.5 trillion in 2005, with total federal obligations standing at $54.6 trillion (see this month's Reporting/Market Focus). With no ability to honor these obligations, the government effectively is bankrupt.
At such debt levels, the markets soon will recoil from lending Uncle Sam whatever he needs. Major buyers of U.S. Treasuries from outside the United States, such as Communist China, already are balking. These investors have funded nearly all net U.S. Treasury debt issuance of the last four years, putting to use the excess dollars flushed into the global markets by the United States' excessive and ever-expanding trade deficit. This practice, however, generated liquidity for the U.S. markets that has helped to depress long-term Treasury yields as well as to boost equity prices.
Although the U.S, government faces ultimate insolvency, it has the same way out taken by most countries faced with bankruptcy. It can print whatever money it needs to create, in order to meet its obligations. The effect of such action is a runaway inflation -- a hyperinflation -- with a resulting, effective full debasement of the U.S. dollar, the world's reserve currency.
In the present environment, the chances for the collapse in money supply needed to generate a consumer price deflation are nil. First, the discipline of the gold standard that helped trigger historical deflations is gone. Second, both from the standpoint of the government's fiscal irresponsibility and from the Fed's standpoint of providing the financial system with whatever liquidity is needed to keep it afloat, the U.S. central bank will be pushing broad money growth to new extremes, not containing it.
Please note: The usual Summary of Current Outlook is excluded this month, because the broad outlook largely is reviewed within the current text. Going forward, this section will be reconstituted next month and then repeated and updated each month following. Any monthly revisions to the text, however, will be highlighted, so that regular readers will have the option of not rereading text they have seen before. Nonetheless, the general outlook rarely changes. As a result, the repetition of some regular themes is necessary and will be found in the general text.
MARKETS PERSPECTIVE
The 2006 U.S. financial markets were distorted meaningfully by excessive dollar investing from outside the United States. This process is likely to reverse in 2007, tanking stocks, spiking interest rates, and pummeling the dollar. Indeed, key to the outlook is what happens to the U.S. dollar. I expect the greenback to be under massive selling pressure in the year ahead.
The Dow Jones Industrial Average, S&P 500, Wilshire 5000 and NASDAQ Composite showed respective annual gains of 16.3%, 15.9%, 13.9% and 9.5% as of year-end 2006. Those returns were against an actual (SGS Alternate) annual inflation rate of about 10%, a 13% gain in the Pound Sterling, a 23% gain in gold and a 46% gain in silver.
So, the stock indices generally kept up with or topped inflation, but they barely kept up with the dollar's declining purchasing power against the pound. Equities lagged sharply the return on precious metals.
Other than for the Fed's further tightening of 100 basis points in the year -- before "pausing" -- interest rates were unusually stable, ending the year with a negatively sloped yield curve (short-term yields higher than long-term yields). The constant-maturity yield on the 3-month Treasury bill moved from 4.08% at year-end 2005, to 5.10% at mid-year 2006 and held at 5.10% at year-end. For the same periods, the 10-year yield move from 4.39% to 5.15% to 4.70%.
As background to the above, the economy fell into deepening recession, while inflation moved to multi-year highs. Both problems largely were ignored by the equity and credit markets, while the inflation and economic difficulties played into the developing pressures favoring gold and hurting the dollar.
Some would contend that the inverted yield curve resulted from market anticipation of the unfolding recession, but the yield curve also has been depressed recently through periods of reportedly strong GDP growth.
What has been at work here is the heavy funding of U.S. Treasuries by foreign investors in recent years. Unwanted dollars glutting the global markets from the ongoing explosive growth in the U.S. trade deficit have been used by accommodating foreign central banks to buy nearly all net debt issuance by the U.S. Treasury in the last several years. Such has kept the U.S. markets flush with liquidity, U.S. long-term interest rates low, and U.S. equities heavily over-priced.
The markets have gotten so out of touch with reality that the yield spread on junk bonds over the "risk-free" Treasuries has narrowed beyond reason, especially if the economy is going into a recession, as an increasing number of analysts on Wall Street anticipate.
With rumblings from central banks as to how they would like to reallocate their currency reserves out of the U.S. dollar, the halcyon days of 2006 are not likely to survive long into the New Year.
U.S. Equities -- Stocks face a number of negative fundamentals, ranging from a recession that will decimate earnings, to higher interest rates that should follow from dollar and inflation problems. The equity markets are the least rational of those followed. I expect the major indices to suffer heavy selling and large declines before year-end 2007.
U.S. Credit Market -- Long-term interest rates did not rise as I predicted during the second half of 2006, but the outlook for higher long-term yields and a return to a positively sloped yield curve remain in play.
Reported inflation levels remain high enough to support traditional long-term yields 200 to 300 basis points above current levels. Look for yields to spike in tandem with heavy selling of the U.S. dollar.
Some in the markets are anticipating a Fed easing early in the New Year to counter the obvious slowing in economic activity. While that would be the expected Fed response, such a move is unlikely and would be short-lived if taken. More likely, the Fed's next move will be to raise interest rates in an effort to stabilize the dollar. Never before has the U.S. central bank faced a dollar crisis with the U.S. financial markets so heavily dependent on foreign capital for liquidity. Therein lies a big problem for the Fed and the equity and the credit markets.
U.S. Dollar -- Recent dollar selling has been relatively minor against what lies ahead. A major sell-off in the greenback is key to the looming breaks in the U.S. equity and credit markets. On a financial-weighted basis, the greenback should end 2007 down at least 30% from current levels, particularly against the Swiss franc, the British pound and the euro, in that order.
With such extremely negative, underlying dollar fundamentals, near-panic selling and disorderly markets remain a good possibility. Driving relative currency values are relative economic activity, trade balance, inflation, interest rates, government financial conditions and political stability. Each factor, including a U.S. recession, an extreme trade deficit, rising inflation, a Fed "pause," an uncontained fiscal crisis, and low Presidential approval ratings, suggests an atmosphere conducive to the heavy dumping of U.S. dollars.
Most of these negative fundamentals have been in place for some time. Dollar selling, however, has been contained as excess dollar inventories and selling pressures have built to the bursting point. When the dollar selling breaks, and that is just a matter of time, the selling will be massive and the currency movements extreme, despite any central bank intervention aimed at stabilizing the dollar's pace of decline. The currency crisis can break without any further warning. As to a trigger, shocks loom in economic and financial reporting, global political developments and the activities of various central bank.
Generally, the weaker the dollar, the greater will be the ultimate inflation pressure and liquidity squeeze in the U.S. capital markets. As shown in the following graph, the U.S. dollar has continued inching lower in recent months.
[Note: Historical data on both dollar series are available for download on the Alternate Data page of www.shadowstats.com. See the July 2005 SGS for methodology.]
U.S. Dollar Indices. The Shadow Government Statistics' Financial-Weighted U.S. Dollar Index (FWD) is based on dollar exchange rates weighted for respective global currency trading volumes. For December, the monthly dollar average fell by 1.55%, after a 1.66% drop in November. The December 2006 average index level of 50.94 (base month of January 1985 = 100.00) was down 7.57% from December 2005, following an annual rate of decline of 6.70% in November.
Moving in the same direction, December' monthly average of the Federal Reserve's Major Currency Trade-Weighted U.S. Dollar Index (TWD) fell by 0.76% for the month, following November's 1.09% decline. December's level of 58.29 (base month of January 1985 = 100.00) was down 5.63% from the year before, against November's annual decline of 5.73%.
The bigger hit taken recently by the SGS series continues to be due to a much lighter weighting of the Canadian dollar in the FWD versus the TWD. The U.S. dollar has done relatively better against is Canadian counterpart.
Gold -- With the gold price averaging around $630 per troy ounce in December, the precious metal remains poised to strike to new highs in the New Year. While price volatility likely will remain extremely high, the underlying fundamentals in terms of dollar weakness, inflation and political instability all should be boosting the precious metals early in 2007.
As mentioned earlier, market concerns as to the Fed's intentions on inflation and debt monetization increasingly will come into play as the greenback faces heavy selling pressures. Underlying fundamentals easily cold push gold above the $1,000 mark in the year ahead, but its longer term outlook is for much higher prices.
Central manipulation, including talk of central gold sales, will mount rapidly as gold prices rise, occasionally slamming gold investors. Yet, central banks know well that they should be increasing their gold holdings, not liquidating them.
As discussed in previous SGS newsletters, and as will be further detailed in the Hyperinflation Series in the months ahead, the eventual complete collapse of the U.S. dollar -- the world's reserve currency -- will force the creation of a new international currency system. In order to gain public acceptance of a new system, gold is likely to be structured at the heart of it.
The updated gold versus oil and Swiss franc graphs show December averages. As we go to press, gold is trading above $630, oil is over $61 and the Swiss franc is at $0.82. Look for all three measures to trade significantly higher in the first half of 2007.
REPORTING PERSPECTIVE
The Big Three Market Movers
While election-year political pressures on the statistical system have passed, needs have shifted heavily over to the Federal Reserve in its efforts to prevent a financial-market and financial-system meltdown. Accordingly, upcoming releases of the major series still will be subject to massaging for the perceived needs of the markets. Nonetheless, the reality of the underlying inflationary recession has become increasingly evident in the popularly followed economic series. Against lagging market expectations, though, most near-term economic reporting will continue to surprise the markets on the downside, while most inflation reporting should surprise the markets on the upside.
Employment/Unemployment -- As discussed in the December 11th Flash Update, the BLS reported seasonally-adjusted November payrolls up by 132,000 (134,000 net of revisions) +/- 106,000, following October's revised gain of 79,000 (previously 92,000). Once again, unusual upward revisions were thrown into prior period reporting. On a year-to-year basis, annual payroll growth slowed sharply to 1.3% in November from 1.5% in October.
The November 2006 payroll growth included a 29,000 upside bias provided by the net birth/death model. In November 2005, the bias was 21,000, and that increased to 63,000 in December, suggesting slight upside bias pressure on the December 2006 reporting.
The household survey, which counts the number of people who have a job, as opposed to the number of jobs counted in the payroll survey, reported a seasonally-adjusted employment gain of 277,000. That number that cannot be reconciled with the payroll data.
The unemployment portion of the household data showed the seasonally-adjusted November U.3 unemployment rate at 4.47% +/- 0.2%, up from 4.42% in October. Unadjusted U.3 rose to 4.3% from 4.1%, while the unadjusted broader U.6 measure rose to 7.8% from 7.6%. Adjusted U.6 eased to 8.0% from 8.1%. Including the long-term "discouraged workers" defined away during the Clinton administration, total unemployment remains roughly 12%.
The latest report was against a background of an ongoing collapse of growth in help-wanted advertising, intensifying weakness in new claims for unemployment insurance and weak purchasing managers employment indices (see the respective sections).
Next Release (January 5): While the payroll survey should be weaker than expected in December, the household survey will include annual revisions to seasonal factors related to unemployment reporting. Such allows any level of unemployment that the BLS cares to report.
Gross Domestic Product (GDP) -- The "final" estimate revision of annualized real growth for third-quarter 2006 reflected little more than statistical noise, revising to 1.96% +/- 3% from 2.21% in the "preliminary" estimate, but still up from the initial reporting of 1.58%. Second-quarter growth was 2.56%, where first quarter growth was 5.58%. The growth estimates for the latest two quarters were statistically indistinguishable from contractions, allowing, with increasingly likely revisions, for eventual formal recession reporting with numbers already in place from the Bureau of Economic Analysis (BEA).
In terms of annual growth, the third-quarter's reported pace revised to 2.96% from 3.02% (initially 2.86%), down from 3.51% in the second quarter. Adjusting for methodological distortions built into GDP reporting over time, the SGS Alternate GDP measure suggests economic reality is much weaker, with a year-to-year annual contraction of still roughly 1.5% for the third-quarter GDP, deepening from a 1.0% drop in the second quarter (see the graph in the Alternate Reality section of the Overview -- Opening Comments).
The GDP inflation rate (deflator) in the third quarter remained understated at 1.88%, revised from 1.77% (initially 1.83%), versus 3.30% in the prior quarter, despite annualized seasonally-adjusted CPI in the third-quarter of 2.94% and of 4.97% in the second quarter.
Growth rates in the alternate GDP measures, the broader Gross National Product (GNP) and the theoretically-equivalent Gross Domestic Income (GDI), also were revised. Third-quarter annualized real GNP growth revised to 1.76% from an initial estimate of 1.91%, down from 2.34% in the second quarter. GNP includes trade flows in factor income (interest and dividend payments) and tends to be hurt by the net-debtor status of the United States.
GDI, which is the income-side equivalent of the consumption-driven GDP, grew at a revised annualized real rate of 3.21% (initially 3.43%) in the third quarter, up from a 0.47% contraction in the second quarter.
Next Release (January 31): The "advance" estimate of fourth-quarter 2006 GDP should be weaker than the third-quarter's showing and to the downside of market expectations, despite what surely will be an exaggerated low level of inflation used to deflate the quarterly growth rate.
Consumer Price Index (CPI) -- As discussed in the December 16th Alert, the BLS reported the seasonally-adjusted November CPI-U was unchanged (down 0.15% unadjusted) from October, following October's 0.49% adjusted monthly drop. Of significance, seasonally-adjusted gasoline fell by 1.6%. In conjunction with the retail sales report, this suggests an understatement of gasoline inflation in the CPI by 3.9% in November, and a corresponding overall 0.2% understatement of the CPI, which is about how much the CPI came in below market expectations.
On a year-to-year basis, annual CPI-U inflation (I.6) rose to 1.97% in November from 1.31% in October. The eight levels of annual inflation, I.1 to I.8, are shown in the table in the Alternate Reality section, as is the plot of the SGS Alternate Consumer Inflation number.
The "experimental" Chained Consumer Price Index (C-CPI-U), the fully substitution based CPI that presumably is the eventual replacement for current CPI reporting, showed annual inflation (I.5) of 1.92% in November, up from 1.56% in October. The annual C-CPI-U inflation dropped below that of the CPI-U after two months of topping the popular measure. Nonetheless, the unusual reporting here highlights a problem in the gimmicked CPI-U weightings.
Adjusted to pre-Clinton methodology (I.7), annual CPI growth was about 5.4% in November, up from 4.7% in October. The SGS Alternate Consumer Inflation Measure (I.8), which reverses gimmicked changes to official CPI reporting methodologies of recent decades, was 9.4% in November, up from 8.9% in October.
Next Release (January 18): Inflation has not peaked, but it will take several months into 2007 to regain its recent high annual rates. With seasonally-adjusted CPI-U down by 0.1% in monthly December 2005 CPI reporting, any monthly reporting above that for December 2006 will add directly onto the annual CPI-U inflation rate.
Inflation surprises still should come in on the upside of weak expectations, both for full as well as core numbers. Increasingly reflecting the slow process of oil prices permeating nearly all levels of business activity, upside movement in core rates, in particular, will tend to shock the markets.
Other Troubled Key Series
Federal Deficit -- As discussed in this month's Reporting/Market Focus, the federal government's fiscal 2006 (fiscal year-end September 30th) deficit, prepared based on generally accepted accounting principles (GAAP), widened to $4.6 trillion from 2005's $3.5 trillion. Such was nearly 19-times the level of the officially-gimmicked 2006 federal budget deficit of $248.2 billion, which was down $70.8 billion from 2005's $318.5 billion.
As a separate measure from the GAAP-based numbers (on an accrual basis) and the official deficit reporting (on a cash basis), the change in gross federal debt is a fair indicator of actual net cash outlays by the government. As of fiscal year-end 2006, the gross federal debt stood at $8.507 trillion, up by $574 billion from 2005, which in turn was up $554 billion from 2004.
For the rolling 12 months through November 2006, the gimmicked deficit was $242.8 billion versus $333.6 in November 2005. As of November 30, 2006, the gross federal debt stood at $8.633 trillion, up by $536 billion from November 2005, which in turn was up $573 billion from November 2004.
Even the official federal deficit should inflate this year, as government finances suffer increasingly from tax revenue losses due to the intensifying recession and relative tax receipt declines after the expiration of recent tax incentives. While GDP growth estimates can be gimmicked, incoming tax receipts (based on consistently applied tax policies) remain an independent estimate of underlying economic reality and eventually will reflect the economy's mounting difficulties.
Initial Claims for Unemployment Insurance -- Annual change in initial claims continued moving into less-negative territory (an economic negative) due to sharp deterioration in recent numbers. New claims averaged over the last eight weeks are up 1.5% from last year, but year-ago comparisons using the 17-week moving average still are distorted by last year's effects of Hurricane Katrina passing through the data. On a smoothed basis for the 17 weeks ended December 23rd, annual change narrowed to a 6.9% decline, from a 7.7% drop as of the November 18th week.
More often than not, week-to-week volatility of the seasonally-adjusted weekly numbers is due to the Labor Department's efforts to seasonally adjust these numbers around holiday periods. The Labor Department has demonstrated an inability to do such adjusting successfully. When the new claims series is viewed in terms of the year-to-year change in the 17-week (four-month) moving average, however, such generally is a fair indicator of current economic activity.
Real Average Weekly Earnings -- Spiked minimally by a 0.2% monthly CPI understatement, November's seasonally-adjusted real earnings rose by 0.2% against October's distorted 1.3% gain. Similarly biased annual growth slowed to 2.6% in November from 3.2% in October.
Variations in the poor quality of reported CPI growth account for most month-to-month volatility in this series. Allowing for the major upside biases built into the CPI-W inflation measure used in deflating the average weekly earnings, annual change in this series continues to signal ongoing severe financial strain on U.S. households and continuing recession.
Retail Sales -- As discussed in the December 16th Alert, the Census Bureau switched to its new sampling for estimating retail sales. On the new basis, seasonally-adjusted November retail sales rose by 1.0% plus or minus a wider error margin of 0.8%, formally 0.7%, and following a revised October decline of 0.1% that had been restated on the new basis to a contraction of 0.4%, against an old basis initial reporting of a 0.2% drop. Of note, gasoline station sales rose by 2.3% from October, suggesting that a like increase in gasoline prices should have been reflected in the November CPI. That did not happen.
When inflation-adjusted year-to-year growth in retail sales falls below 1.8% (using the official CPI-U for deflation), such signals recession. That signal was generated in June 2006. Before inflation adjustment, November growth was up 5.6% from the year before, a 3.6% real growth rate net of the heavily understated annual CPI growth.
Next Release (January 12): December retail sales should come in below expectations, generally reflecting the recession and a less-than-robust holiday shopping season. Inflation-adjusted growth should be negative on a monthly basis, with annual real growth also slowing sharply.
Industrial Production -- As discussed in the December 16th Alert, the Fed went through its annual benchmark revision to industrial production, and found, as it usually does, that production activity in recent years had been weaker than previously reported. Such suggests an eventual downward revision to growth rates of the last several years as currently reported for the GDP.
The seasonally-adjusted 0.2% monthly gain for November industrial production followed a flat October that previously had been up by 0.2%. November annual growth slowed to 3.8%.
Although the manufacturing sector was in contraction, per the November purchasing managers survey, such did not show up in the Fed's survey. Watch out for possible distortions to the December industrial production number from the unusually mild weather in the Northeast.
Next Release (January 17): Look for industrial production to contract in December, reflecting the recession, the purchasing managers survey, and utility usage distortions from unusual December weather patterns. Monthly contractions in this series shortly should become regular.
New Orders for Durable Goods -- The highly volatile durable goods orders rebounded in November by a seasonally-adjusted 1.9% (2.0% net of revisions), after a revised 8.2% (was 8.3%) decline in October. November's orders were up just 0.3% from the year before, a near-recessionary level for a second month.
The widely followed nondefense capital goods orders were down 0.2% in November, following October's 14.8% drop (previously down 15.6%). November's annual growth rate for nondefense capital goods orders was down a recessionary 7.7%.
Durable goods orders lost its status as a solid leading economic indicator when the semi-conductor industry stopped reporting new orders.
Trade Balance -- As discussed in the December 16th Alert, the unbelievable $5.4 billion monthly decline in the seasonally-adjusted October trade deficit to $58.9 billion from September's $64.3 billion was more than accounted for by a plunge in reported oil import prices, without which, the trade deficit would have risen to $64.9 billion. The problem with the report was that accelerated reporting of dropping oil prices for imports already had fully accounted for the recent decline in oil prices.
Of significance to the "advance" estimate of fourth-quarter 2006 GDP, which is commonly reported net of inflation, this deficit "narrowing" due to prices will really be a negative, instead of a positive, for the government's GDP growth estimate.
Next Release (January 10): The November trade deficit should rebound some from October's understatement, rising beyond consensus forecasts. The months ahead will see a pattern of regularly increasing deficits that once again will be setting new records before second-quarter 2007.
Consumer Confidence -- December confidence measures again were mixed. The Conference Board's November consumer confidence -- adjusted by suspect seasonal factors -- rose by 3.5%, after a revised 0.2% increase in November. The unadjusted University of Michigan's consumer sentiment declined by 0.4%, following a 1.6% drop in November.
On a year-to-year basis into November, the damage done to confidence in 2005 by the severe hurricane season largely was responsible for the near-term gains seen in annual growth patterns. On a three-month moving-average basis for December, annual growth in the Conference Board's measure eased to 11.2% from 16.7% in November, while the University of Michigan number was up by 12.2%, versus a 16.5% gain in November. These lagging, not leading, indicators still are suggesting that the economy is in trouble.
Short-Term Credit Measures -- Annual growth in consumer credit showed some problems, particularly against the backdrop of what was the beginning of the holiday shopping season. Short-term commercial credit measures, however, remained strong, holding double-digit percentage annual growth.
Growth in seasonally-adjusted consumer credit declined by 0.1% for the month of October, with annual growth easing to 4.2%, from a revised 4.3% (was 3.7%) in September. Without real (inflation-adjusted) growth in personal income, growth in the real personal consumption component of GDP cannot be supported, except by debt expansion or savings liquidation. Consumer debt expansion, though increasing on an annual basis, has stalled on a monthly basis, suggesting a serious constraint on economic growth.
Annual growth in commercial paper outstanding remained strong in November at 17.8%, up from October's 17.6%. Annual growth in commercial and industrial loans slowed slightly to 15.0% in November from a revised 15.4% (was 14.9%) in October. Strong growth in the commercial credit measures can signal credit needs tied either to rising sales and receivables/inventory needs, or to slowing sales and slowing collections and involuntarily rising inventories.
Producer Price Index (PPI) -- Running somewhat counter to the serious understatement of monthly CPI inflation, the seasonally-adjusted November finished goods PPI jumped by 2.0% (0.8% unadjusted). At work appears to be a much needed catch up in the annual seasonal distortions (adjustments) published by the BLS. November's increase offset October's 1.6% monthly decline (down 1.2% unadjusted), but still was shy of recovering levels seen before September's 1.3% drop (down by 1.1% unadjusted). November's annual PPI inflation rebounded to a gain of 0.9% following October's 1.6% contraction. Seasonally-adjusted November intermediate goods rose by 0.7% for the month, while crude goods exploded by 15.7%.
Next Release (January 17): Despite the large component of random volatility in monthly price variations, PPI inflation reporting over the next six-to-nine months generally will exceed still-depressed expectations. December reporting, should continue a general upside trend in monthly and annual PPI reporting. Core inflation also should resume offering upside surprises to consensus forecasts, despite the increasingly poor quality of reporting.
Better-Quality Numbers
The following numbers are generally good-quality leading indicators of economic activity and inflation that offer an alternative to the politically-hyped numbers when the economy really is not so perfect. In some instances, using a three-month moving average improves the quality of the economic signal and is so noted in the text.
Economic Indicators
Purchasing Managers Survey: Manufacturing New Orders -- The key November index components fell to outright contraction levels (below 50.0) for the first time since 2003. For example, November new orders fell 6.5% to 48.7 from 52.1 in October. As an SGS early warning indicator of a pending major economic shift, the new orders measure breached its fail-safe point in mid-2005, generating a signal of pending recession.
Distortions from suspect seasonal-adjustment factors from the Commerce Department are overcome by viewing the series using year-to-year change on a three-month moving average basis. On that basis, the November new orders index fell by 13.7% following October's 9.0% contraction. The index gradually has notched lower from its peak annual growth of 42.6% in April of 2004.
Published by the Institute for Supply Management (ISM), the new orders component of the purchasing managers survey is a particularly valuable indicator of economic activity. The index is a diffusion index, where a reading below 50.0 indicates contracting new orders.
Moving in tandem with new orders, production and employment, the overall November ISM manufacturing index dropped to 49.5 from October's 51.2. An index level below 50.0 indicates a contracting manufacturing sector. The November employment component moved to 49.2 from October's 50.6 reading.
The service-sector ISM index does not have much meaning related to overall business activity, since new order activity at law firms, hospitals or fast-food restaurants have little obvious relationship to broad economic activity. That said, the overall November services index rose to 58.9 from October's level of 57.1.
Both the services employment and prices paid components, however, have some meaning. The November employment component notched higher to 51.6 from 51.0 from 53.6 in October. The prices paid component is covered in the Inflation Indicators.
Help-Wanted Advertising Index (HWA) -- The November help-wanted advertising index held at 30, the same as in October, but September's initial reading of 30 revised to 29, the lowest level seen since Sputnik was first orbiting Earth.
The series indicates rapidly deteriorating employment conditions. While the index never recovered from the 2000 recession, its recent, deepening plunge -- annual change is down 21.3% on a three-month moving average basis -- signals a renewed and rapid contraction in economic activity.
Housing Starts -- Although seasonally-adjusted November housing starts rose by 6.7% +/- 10.1% for the month, annual change plunged by 25.5%, following October's 27.3% decline. The annual change on a three-month moving-average basis has declined to a year-to-year drop of 24.3%, the worst reading since the depths of the 1990/1991 recession. Such continued to generate an intensifying recession signal.
In related data, respective rates of annual contraction for November new- and existing-home sales were 15.3% and 10.5%. Although the annual rates of change were less negative than in October, the indicated activity remained consistent with a sharp economic downturn.
Money Supply -- Annual growth in M3 accelerated to 10.8% in December, up from an upwardly revised 10.4% in November. The increasing upturn in M3 growth would be enough to begin tickling inflation concerns in the financial markets, if only the Fed were still reporting M3. The reported M3 growth is per the SGS Continuing M3 Series reporting, with December's number estimated on three weeks of data. The upward revision to November's initial annual growth estimate of 10.1% reflected upward revisions to Federal Reserve reporting of M2 and large time deposits at commercial banks.
[Note: Historical annual growth data for the money supply series, including the ongoing SGS estimates of M3, are available for download on the Alternate Data page of www.shadowstats.com. See the August 2006 SGS for methodology.]
The December data are based on three weeks of data for the month. Before inflation adjustment, monthly seasonally-adjusted December M1 and M2 respectively fell an estimated 0.9% and rose by 0.5%, after a respective 0.5% decline and 0.5% increase in November, and 0.8% and 0.9% gains in October. Month-to-month M3 change was approximately 1.1% for December and 1.0% in November.
Annual growth in December for monthly M1 fell by 1.0%, versus a 0.5% contraction in November, while annual M2 growth rose held at 5.1%. Net of still-distorted annual CPI inflation, real annual growth rates for December M1 and M2 remained consistent with the ongoing recession, with December's M1 and M2 year-to-year rates of change down by roughly 3.1% and up 2.9%, respectively. On a three-month moving-average basis, the December inflation-adjusted annual rates of change were down 2.4% and up 3.1%, levels that still were underwater using the old-style CPI.
Inflation Indicators
Purchasing Managers Surveys: Prices Paid Indices -- In line with surging PPI reporting, but counter to the soft monthly data on the CPI, the pricing components of both purchasing managers surveys rose sharply. On the manufacturing side, the November prices paid diffusion index jumped 13.8% to a reading of 53.5 from October's 47.0. On a three-month moving average basis, November's annual change was down by 30.0% versus October's 19.4% contraction.
On the non-manufacturing side, the November prices diffusion index rose 7.1% to 55.6 from 51.9 in October. On a three-month moving average basis, November's annual change was down by 29.6% against October's annual 17.6% decline.
Published by the Institute for Supply Management (ISM), the prices paid components of the purchasing managers surveys are reliable leading indicators of inflationary pressure. The measures are diffusion indices, where a reading above 50.0 indicates rising inflation.
Oil Prices -- The monthly-average West Texas Intermediate Spot (St. Louis Fed) rose to $59.37 per barrel in November, up 0.8% from October's $58.88. The November average was up 1.8% from the year before, against October's annual 5.6% rate of decline. Oil generally traded above $60.00 per barrel in December, with the nearby contract closing at $61.05 on Friday. The December monthly average will be up both on month-to-month and year-to-year bases.
Spot oil prices will continue to gyrate, but generally will move higher in the year ahead. Such reflects OPEC manipulations aimed at price support and Middle East tensions that are mounting anew, now that the election has passed. Further, gone are annual price change comparisons against the market distortions of a year ago from the devastating 2005 hurricane season.
Also in play is the dollar-based pricing of oil. U.S. Dollar weakness is the equivalent of an oil price cut for oil purchasers denominated in an appreciating currency. Market forces tend to balance out such matters by pushing dollar-based oil prices higher. Even worse for the U.S. markets, though, is the developing trend of pricing oil in something other than dollars. Where Iran has moved to euro pricing, other OPEC members will not be far behind if the dollar faces heavy selling in the New Year.
Despite recent extreme volatility, oil prices will remain at highly inflationary levels and will continue as a major contributing factor to the United States' inflation problems. The historically high oil prices still are working their way through all levels of U.S. economic activity, ranging from transportation and energy costs, to material costs in the plastics, pharmaceutical, fertilizer, chemical industries, etc. Cost pressures already have only just started to show up in the so-called "core" inflation measures. Again, these broad inflationary pressures will remain intact despite any near-term oil price volatility.
Please note that while downside oil price movements are picked up more quickly and fully by the BLS in its inflation measures than are upside movements, the general trend in both CPI and PPI reporting -- at both the aggregate and core levels -- will be to the upside at least through mid-2007.
Background Material/Reporting Coverage
The coverage and available prior material are detailed below for various series. Data reported with a less-than-monthly frequency also are updated here or in the Reporting/Market Focus.
Quarterly/Annual Reporting -- Most series analyzed are published on a monthly or weekly basis. Followed economic/market series that are published with less-than-monthly frequency include:
Annual:
* Financial Statements of the United States Government (see the Supplement to December 2005 SGS; latest analysis is the SGS Alert of December 16, 2006 and the current Market/Reporting Focus for the December 2006 SGS).
* Income Variance/Dispersion (most recent analysis was is in the September 2006 SGS; next analysis is due September 2007).
Quarterly:
* Flow of Funds Accounts of the United States (the most recent analysis was in the October 2006 SGS; the next analysis is due in the January 2007 SGS).
Reporting/Market Foci -- The various economic and financial-market series are being addressed in a monthly "Reporting/Market Focus," with this month's analysis covering the 2006 GAAP-based financial statements of the U.S. Government. Employment, GDP, CPI and the Federal Deficit separately are explored in the background article "A Primer on Government Economic Reports," available on the Home page of www.shadowstats.com.
The series detailed so far in the Reporting Foci or background articles are listed below. The referenced SGS publications are available on the Archives page of www.shadowstats.com.
* Consumer Confidence (November 2004 SGS).
* Consumer Price Index (an original background article [updated October 2006], October 2005 SGS, alternate numbers introduced August 2006 SGS).
* Credit Measures, Short-Term (August 2005 SGS).
* Durable Goods, New Orders for (May 2006 SGS).
* Employment/Unemployment (an original background article, alternate measures (April 2005 SGS).
* Federal Deficit (an original background article, update in the Alert of July 7, 2005, update in Supplement to December 2005 SGS, update in Alert of December 16, 2006 and the December 2006 SGS).
* Gross Domestic Product (an original background article, alternate numbers introduced August 2006).
* Help Wanted Advertising (January 2006 SGS).
* Housing Starts and related housing statistics (June 2006 SGS, November 2006).
* Income Variance/Dispersion (September 2005 SGS, September 2006 SGS).
* Industrial Production (January 2005 SGS).
* Money Supply (Part I / SGS Early Warning System - May 2005 SGS, Part II - June 2005 SGS, M3 update November 2005 Supplement, M2 update March 2006 SGS, M3 continuing series introduced August 2006).
* Producer Price Index (April 2006 SGS).
* Productivity (October 2006 SGS).
* Purchasing Managers Survey (February 2006 SGS).
* Retail Sales (March 2005 SGS).
* SGS Early Warning System (May 2005 SGS, June 2005 SGS).
* Trade Balance (December 2004 SGS).
* Unemployment Insurance, Initial Claims for (February 2005 SGS).
* U.S. Dollar Indices, Financial- and Trade-Weighted (July 2005 SGS).
Reporting/Market Focus (December 2006) --
U.S. Government's Fiscal Condition Continues Its Collapse
The text of the December 16, 2006 Alert related to the government's GAAP-based 2006 financial statements is repeated below. The following paragraph is added for clarification purposes:
The U.S. Treasury heavily reported the rapidly increasing shortfalls in the unfunded liabilities for Social Security and Medicare in its financial statements, but referred to the liabilities as off balance sheet. The actual $4.6 trillion deficit for 2006 is calculated with those numbers on balance sheet, as the year-to-year change in the negative net worth of the federal government shown in the table below.
That accounting is what a U.S. corporation would have to show. The Administration's rationale as to why Social Security and Medicare should remain off balance sheet runs along the lines that the government always has the option of changing the Social Security and Medicare programs. That said, there clearly is no one in political Washington willing to go public with the concept of eliminating or substantially cutting those programs.
December 16th Alert on the 2006 Financial Statement of the United States Government:
2006 GAAP-Based Federal Deficit Jumps to $4.6 Trillion
Total Federal Obligations at $54.6 Trillion
Yesterday, the U.S. Treasury published its annual generally-accepted-accounting-principles (GAAP) basis financial statement, signed off on by Treasury Secretary Henry M. Paulson, Jr. The consolidated statements show that the actual annual federal deficit for fiscal year ended September 30, 2006 was $4.6 trillion, up from $3.5 trillion in 2005. Total federal obligations at year-end were $54.6 trillion, up from $50.0 trillion in 2005.
The actual deficit number was nearly 19-times the size of the gimmicked "official" deficit for 2006 of $248 billion. Total obligations were 4.2-times annual U.S. GDP.
The above GAAP numbers include accounting for the year-to-year change in the net present value of unfunded liabilities in social insurance programs such as Social Security and Medicare. The Treasury notes that these liabilities are "not considered liabilities on the balance sheet." While Treasury has pushed for such an accounting standard for the federal government, it would not have a choice as to reporting these obligations if it were a corporation such as General Motors.
Net of the obligations for Social Security and Medicare, the GAAP-based deficit narrowed to $450 billion in 2006 from $760 billion 2005. Such is not credible give the bookkeeping for Katrina relief and the Iraq War. While these numbers likely involve some accounting shenanigans -- as did the last reported annual deficit decline in the 2004 -- the method is not obvious given a quick review of the 172-page document. The issue will be looked at more closely in the December SGS. Nonetheless the published estimates are roughly double the "official" deficits reported for 2005 and 2006.
The 2006 GAAP statement can be found on the Treasury's Web site, under Financial Management Services at: http://www.fms.treas.gov/fr/index.html
The GAAP numbers in the above table are derived from or published in the tables on pages 3, 6 and 13 of the Report,
As usual, the Government Accountability Office (GAO) -- formerly the General Accounting Office -- would not certify the statement, due to "material weaknesses in financial reporting" (page 27). The GAO, which uses a less expensive definition (on an open versus closed group basis) than the Treasury in its Social Security and Medicare numbers, noted (page 28): "that the Federal government's fiscal exposures total approximately $50 trillion as of September 20, 2006, an increase of about $4 trillion over September 30, 2005, and up from about $20 trillion as of September 30, 2000.
As noted in SGS analyses of prior years' statements, the current GAAP-based deficit is beyond containment in the present environment. Severe political constraints limit any meaningful reduction of the Social Security and Medicare programs, while addressing the issue with taxes is impossible. If federal income taxes were adjusted to as to seize 100% of all salaries and wages earned in the United States, the government's operations still would be in deficit. Contrary to the suggestion of Treasury Secretary Paulson, the United States cannot grow its way out this shortfall. The problem is out of control.
Upcoming Reporting/Market Focus for January --
Fudged Flow of Funds Accounts?
Questionable statistical practices at the Board of Governors of the Federal Reserve System go well beyond the elimination of M3 reporting. Unusual patterns and revisions are showing up in the Fed's Flow of Funds Accounts that show the sources and uses of cash and credit within the U.S. financial system and economy. These anomalies are explored.
___________________________________________
January's "Shadow Government Statistics" newsletter is targeted for release near the end of the month. Its posting on the Web site, as well as all interim Flash Updates and Alerts, will be advised immediately by e-mail.
Issue Number 26
January 2, 2007
__________
Recession Recognition Likely in 2007
Dollar Poised for 30% Plunge
Dollar, Debt Monetization and Oil Prices Boost Inflation Outlook
Gold Easily Could Top $1,000
Fed to Tighten in Dollar Defense?
Equities and Bonds to Suffer
Hyperinflationary Depression Likely by 2010
The U.S. economy and financial markets face significant peril in 2007, with the dollar sitting on the brink of a major collapse. The positive 2006 U.S equity markets and reasonably tranquil credit markets belie the pending turmoil that already has been set in motion by a rapidly deepening inflationary recession and exacerbated by the de facto long-term insolvency of the U.S. government.
Financial concerns in the year ahead should become dominated by growing recognition of a severe structural recession that is beyond traditional remedies, high inflation against which the Fed will appear impotent, and a sharp loss in the foreign exchange value of the U.S. currency. In conjunction with the inflation woes, the dollar crisis will lead to significant loss in the greenback's global purchasing power.
This environment will not be a healthy one for equity and bond prices, as the dollar's weakness increasingly will mirror the flight of foreign capital and liquidity from the U.S. markets. On a financial-weighted basis, the dollar has the potential to lose more than 30% of it value. Gaining from these difficulties will be the precious metals, particularly gold, which has the potential easily to push above $1,000 per troy ounce in the year ahead. Enhancing the demand for that safe-haven metal likely will be continued deterioration in the U.S. and global political environment.
Ultimately, the current circumstance will evolve into a hyperinflationary depression. Although such is not likely until the end of the decade, that financial end game for the current markets will tend to come sooner rather than later and will break with surprising speed when it hits. As discussed below, this is not likely to be a deflationary depression.
What lies ahead for 2007 and 2008 will be severe enough and financially painful enough to affect the outcome of the 2008 presidential election. Historically, the concerns of the electorate have been dominated by pocketbook issues. Prior to gimmicked methodologies making the reporting disposable personal income worthless, that measure was an excellent predictor of presidential elections.
In every presidential race since 1908, in which consistent, real (inflation-adjusted) annual disposable income growth was above 3.3%, the incumbent party holding the White House won every time. When income growth was below 3.3%, the incumbent party lost every time. Again, with redefinitions to the national income accounts in the last two decades, a consistent measure of disposable income as reported by the government has disappeared, but odds are quite high that the numbers for 2008 would favor an incumbent loss, i.e. a victory for the Democrats. Where I always endeavor to keep my political persuasions separate from my analyses, for purposes of full disclosure, my background is as a conservative Republican with a libertarian bent.
What follows or coincides politically with a hyperinflationary depression offers a wide variety of possibilities, but the political status quo likely would not continue. Times would be financially painful enough to encourage the development of a third party that could move the Republicans or Democrats to third-party status in the 2012 election.
Recession Recognition Likely in 2007. The 2005 to 2008 recession is getting worse, and continues to be reflected in a number of key economic series, ranging from retail sales to the purchasing managers survey, which showed an outright decline in November manufacturing activity. The various employment indicators remain in deterioration, while payroll growth broadly remains statistically indistinguishable from contraction.
The U.S. economy is in a deepening and protracted recession that likely will endure through 2007 and into at least 2008. With recent economic history properly accounted for, this downturn is the second leg of a double-dip recession that began with the downturn in 2000. The economic contraction is structural in nature, driven by the loss of production jobs to offshore manufacturing facilities in recent decades.
The effect of this structural change is that most consumers are unable to sustain adequate income growth beyond the rate of inflation. The only way that personal consumption -- the dominant component of GDP -- can grow in such a circumstance is for the consumer to take on new debt or liquidate savings. Both those factors are short-lived and have reached untenable extremes.
The federal government and the Federal Reserve also are in untenable positions, with standard economic stimuli unavailable. From the standpoint of the federal government, traditional fiscal stimulus in the form of tax cuts or increased federal spending have reached their practical limits with the actual annual budget deficit running out of control at $4.6 trillion per year (see this month's Reporting/Market Focus).
From the Fed's standpoint, it can neither stimulate the economy nor contain inflation. Holding or lowering rates will do little to stimulate the structurally-impaired economy, and raising rates may become necessary in defense of the dollar. Similarly, raising rates will do little to contain a non-demand driven inflation, such as seen in the current circumstance that is so heavily affected by high oil prices.
Under such circumstance, this protracted inflationary recession is deepening with few, if any prospects of a looming turnaround. It is the worst of all worlds for the U.S. dollar and the domestic equity and credit markets.
Inflationary Pressures Will Mount. While annual CPI inflation began its rebound in November, official reporting still meaningfully understated the CPI level due to the continued overzealous counting of energy deflation that already had run its course. More in line with reality was a sharp monthly rebound in the PPI, as well as rising price indices in the both the manufacturing and non-manufacturing purchasing managers surveys.
Of some concern, annual M3 growth is accelerating, picking up to 10.8% in December from 10.4% in November. Such is enough to begin raising issues of inflationary pressures from excessive monetary growth.
Further, Although the U.S. dollar has seen only minor selling pressure, so far, a major sell-off looms, and with that also will come significant inflationary pressures.
By mid-year, annual CPI inflation once again will be pushing 5%, assuming no further sharp spikes in oil prices and no massive dollar sell-off. Oil and dollar problems would accelerate the rise in reported inflation and increase its scope in the year ahead.
Alternate Realities. This section regularly covers the Shadow Government Statistics (SGS) alternate measures of official CPI and GDP reporting. When a government economic measure does not match common public experience, it has little use outside of academia or the spin-doctoring rooms of the Fed and Wall Street.
Effects of gimmicked methodological changes have been removed from the official series so as to reflect more accurately the common public experience, as embodied by the post-World War II CPI and the pre-Reagan-Era GDP. The methodologies for the series are discussed in the August 2006 SGS.
GDP. The alternate third-quarter GDP growth reflects the "final" estimate revision, with many of the methodological gimmicks of recent decades removed. The alternate third-quarter inflation-adjusted annual (year-to-year) GDP growth rate is a decline of roughly 1.5% versus the official 3.0% gain.
[Note: Historical data on both the official and SGS-Alternate GDP series are available for download on the Alternate Data page of www.shadowstats.com.]
CPI. The gimmicked annual core inflation rates eased again, slightly, in November, as regular inflation reporting began to rebound. With high oil prices continuing to permeate broad economic activity, both core and regular inflation reporting annual should resume/continue their upside movements with the December data.
Eight Levels of Inflation
Annual Inflation for September to November 2006
Measure Sep Oct Nov
I.1 Core PCE Deflator 2.4% 2.4% 2.2%
I.2 Core C-CPI 2.7% 2.5% 2.3%
I.3 Core CPI-U 2.9% 2.7% 2.6%
I.4 PCE Deflator 1.9%r 1.5% 1.9%
I.5 C-CPI 2.2% 1.6% 1.9%
I.6 CPI-U 2.1% 1.3% 2.0%
I.7 Pre-Clinton CPI-U 5.2% 4.7% 5.4%
I.8 SGS Alternate Consumer Inflation 9.4% 8.9% 9.4%
Notes: I.1 to I.3 reflect the core inflation rates, respectively,
of the substitution-based personal consumption expenditure (PCE)
deflator, the Chained-CPI-U and the geometrically-weighted CPI-U.
I.4 to I.6 are the same measures with energy and food inflation
included. The CPI-U (I.6) is the measure popularly followed by
the financial press, when the media are not hyping core inflation.
I.7 is the CPI-U with the effects of geometric weighting (Pre-
Clinton Era as estimated by SGS) reversed. This is the top series
in the CPI graph on the SGS home page www.shadowstats.com.
I.8 reflects the SGS Alternate Consumer Inflation measure, which
reverses the methodological gimmicks of the last 25 years or so,
plus an adjustment for the Clinton-Era geometric weighting that is
not otherwise accounted for in BLS historic bookkeeping.
[Note: Historical data on both the official and SGS-Alternate CPI series are available for download on the Alternate Data page of www.shadowstats.com.]
This is the first in a series of articles on the greatest threat facing the U.S. economy and financial markets, a hyperinflationary depression. The current SGS explores why the system faces hyperinflation instead of deflation. The January SGS will discuss how the crisis could break and explores approaches to preserving wealth and assets in the turbulent times ahead. The February SGS will discuss business operations in, and day-to-day living with, a hyperinflation.
Fire and Ice
Some say the world will end in fire,
Some say in ice.
From what I've tasted of desire
I hold with those who favor fire.
But if it had to perish twice,
I think I know enough of hate
To say that for destruction ice
Is also great
And would suffice.
-- Robert Frost
As to the fate of the developing U.S. great depression, it will encompass the fire of a hyperinflation, instead of the ice of deflation seen in the major U.S. depressions prior to World War II. What promises hyperinflation this time is the lack monetary discipline formerly imposed by the gold standard and a Federal Reserve dedicated to preventing a collapse in the money supply and the implosion of an extremely over-leveraged domestic financial system.
The differences between recession, depression and great depression are defined here, because meaningful definitions have not been published otherwise. Before World War II, all economic contractions were called depressions. A "recession" was the down-leg of a depression, and became a post-World War II euphemism for depression, when the economy contracted for at least two consecutive quarters. While no one involved in the GDP reporting or recession determination process has had to define what might be considered a "depression" since then, I have found common ground with other economists in defining the terms by the magnitude of economic contraction.
From peak to trough in the economic cycle, an inflation-adjusted decline in GDP of less than 10% is considered a recession. A decline of 10% or more is a depression, and a decline of 25% or more is a great depression. On that basis, there has been the one Great Depression. Most of the economic contractions before that were depressions. All business downturns since World War II -- as officially reported -- have been recessions.
Shown below are two graphs measuring the level of consumer prices since 1665 in the American Colonies and later the United States. We have published the first graph before. It shows what appears to be a fairly stable level of prices up to the founding of the Federal Reserve in 1913 and Franklin Roosevelt's abandoning of the gold standard in 1933. Then, inflation takes off in a manner not seen in the prior 250 years, and at an exponential rate when viewed using the SGS Alternate Measure of Consumer Prices in the last several decades. The price levels shown prior to 1913 were constructed by Robert Sahr of Oregon State University. Price levels since 1913 either are Bureau of Labor Statistics (BLS) or SGS based, as indicated.
The magnitude of the increase in price levels in the last 50 years, however, visually masks in the first graph the inflation volatility of the earlier years. That volatility becomes evident in the second graph, with inflation history shown only through 1960.
What is shown in the second graph is that up through the Great Depression, regular periods of inflation -- usually seen around wars -- have been offset by periods of deflation. Particular inflation spikes can be seen at the time of the American Revolution, the War of 1812, the Civil War, World War I and World War II.
The inflation peaks and the ensuing post-war depressions and deflationary periods tied to the War of 1812, the Civil War and World War I show close to 60-year cycles, which is part of the reason some economists and analysts have been expecting a deflationary depression in the current period. There is some reason behind 30- and 60-year financial and business cycles, as the average difference in generations in the U.S. is 30 years, going back to the 1600s. Accordingly, it seems to take two generations to forget and repeat the mistakes of one's grandparents. Similar reasoning accounts for other cycles that tend to run in multiples of 30 years.
Aside from minor average annual price level declines in 1944 and 1955, the United States has not seen a deflationary period in consumer prices since before World War II. The reason for this is the same as to why there has not been a formal depression since before World War II: the abandonment of the gold standard and recognition by the Federal Reserve of the impact of monetary policy on the economy.
The gold standard was a system that automatically imposed and maintained monetary discipline. Excesses in one period would be followed by a flight of gold from the system and a resulting contraction in the money supply, economic activity and prices.
Faced with the Great Depression, and unable to stimulate the economy partially due to the monetary discipline imposed by the gold standard, Franklin Roosevelt used those issues as an excuse to abandon gold and to adopt close to a fully fiat currency under the auspices of what I call the debt standard, where the government effectively could print and spend whatever money it wanted to.
Roosevelt's actions were against the backdrop of the banking system being in a state of collapse. The Fed stood by twiddling its thumbs as banks failed and the money supply imploded. A depression collapsed into the Great Depression, with intensified price deflation. Importantly, a sharp decline in broad money supply is a prerequisite to goods price deflation. Messrs Greenspan and Bernanke are students of the Great Depression period and, as Fed Chairmen, respectively vowed not to allow a repeat of the 1930s money supply collapse.
Where Franklin Roosevelt abandoned the gold standard and its financial discipline for the debt standard, eleven successive administrations have pushed the debt standard to the limits of its viability. This is particularly evident in the GAAP-based financial statements of the U.S. government, which show the actual federal deficit at $4.6 trillion for 2006 alone, up from $3.5 trillion in 2005, with total federal obligations standing at $54.6 trillion (see this month's Reporting/Market Focus). With no ability to honor these obligations, the government effectively is bankrupt.
At such debt levels, the markets soon will recoil from lending Uncle Sam whatever he needs. Major buyers of U.S. Treasuries from outside the United States, such as Communist China, already are balking. These investors have funded nearly all net U.S. Treasury debt issuance of the last four years, putting to use the excess dollars flushed into the global markets by the United States' excessive and ever-expanding trade deficit. This practice, however, generated liquidity for the U.S. markets that has helped to depress long-term Treasury yields as well as to boost equity prices.
Although the U.S, government faces ultimate insolvency, it has the same way out taken by most countries faced with bankruptcy. It can print whatever money it needs to create, in order to meet its obligations. The effect of such action is a runaway inflation -- a hyperinflation -- with a resulting, effective full debasement of the U.S. dollar, the world's reserve currency.
In the present environment, the chances for the collapse in money supply needed to generate a consumer price deflation are nil. First, the discipline of the gold standard that helped trigger historical deflations is gone. Second, both from the standpoint of the government's fiscal irresponsibility and from the Fed's standpoint of providing the financial system with whatever liquidity is needed to keep it afloat, the U.S. central bank will be pushing broad money growth to new extremes, not containing it.
Please note: The usual Summary of Current Outlook is excluded this month, because the broad outlook largely is reviewed within the current text. Going forward, this section will be reconstituted next month and then repeated and updated each month following. Any monthly revisions to the text, however, will be highlighted, so that regular readers will have the option of not rereading text they have seen before. Nonetheless, the general outlook rarely changes. As a result, the repetition of some regular themes is necessary and will be found in the general text.
The 2006 U.S. financial markets were distorted meaningfully by excessive dollar investing from outside the United States. This process is likely to reverse in 2007, tanking stocks, spiking interest rates, and pummeling the dollar. Indeed, key to the outlook is what happens to the U.S. dollar. I expect the greenback to be under massive selling pressure in the year ahead.
The Dow Jones Industrial Average, S&P 500, Wilshire 5000 and NASDAQ Composite showed respective annual gains of 16.3%, 15.9%, 13.9% and 9.5% as of year-end 2006. Those returns were against an actual (SGS Alternate) annual inflation rate of about 10%, a 13% gain in the Pound Sterling, a 23% gain in gold and a 46% gain in silver.
So, the stock indices generally kept up with or topped inflation, but they barely kept up with the dollar's declining purchasing power against the pound. Equities lagged sharply the return on precious metals.
Other than for the Fed's further tightening of 100 basis points in the year -- before "pausing" -- interest rates were unusually stable, ending the year with a negatively sloped yield curve (short-term yields higher than long-term yields). The constant-maturity yield on the 3-month Treasury bill moved from 4.08% at year-end 2005, to 5.10% at mid-year 2006 and held at 5.10% at year-end. For the same periods, the 10-year yield move from 4.39% to 5.15% to 4.70%.
As background to the above, the economy fell into deepening recession, while inflation moved to multi-year highs. Both problems largely were ignored by the equity and credit markets, while the inflation and economic difficulties played into the developing pressures favoring gold and hurting the dollar.
Some would contend that the inverted yield curve resulted from market anticipation of the unfolding recession, but the yield curve also has been depressed recently through periods of reportedly strong GDP growth.
What has been at work here is the heavy funding of U.S. Treasuries by foreign investors in recent years. Unwanted dollars glutting the global markets from the ongoing explosive growth in the U.S. trade deficit have been used by accommodating foreign central banks to buy nearly all net debt issuance by the U.S. Treasury in the last several years. Such has kept the U.S. markets flush with liquidity, U.S. long-term interest rates low, and U.S. equities heavily over-priced.
The markets have gotten so out of touch with reality that the yield spread on junk bonds over the "risk-free" Treasuries has narrowed beyond reason, especially if the economy is going into a recession, as an increasing number of analysts on Wall Street anticipate.
With rumblings from central banks as to how they would like to reallocate their currency reserves out of the U.S. dollar, the halcyon days of 2006 are not likely to survive long into the New Year.
U.S. Equities -- Stocks face a number of negative fundamentals, ranging from a recession that will decimate earnings, to higher interest rates that should follow from dollar and inflation problems. The equity markets are the least rational of those followed. I expect the major indices to suffer heavy selling and large declines before year-end 2007.
U.S. Credit Market -- Long-term interest rates did not rise as I predicted during the second half of 2006, but the outlook for higher long-term yields and a return to a positively sloped yield curve remain in play.
Reported inflation levels remain high enough to support traditional long-term yields 200 to 300 basis points above current levels. Look for yields to spike in tandem with heavy selling of the U.S. dollar.
Some in the markets are anticipating a Fed easing early in the New Year to counter the obvious slowing in economic activity. While that would be the expected Fed response, such a move is unlikely and would be short-lived if taken. More likely, the Fed's next move will be to raise interest rates in an effort to stabilize the dollar. Never before has the U.S. central bank faced a dollar crisis with the U.S. financial markets so heavily dependent on foreign capital for liquidity. Therein lies a big problem for the Fed and the equity and the credit markets.
U.S. Dollar -- Recent dollar selling has been relatively minor against what lies ahead. A major sell-off in the greenback is key to the looming breaks in the U.S. equity and credit markets. On a financial-weighted basis, the greenback should end 2007 down at least 30% from current levels, particularly against the Swiss franc, the British pound and the euro, in that order.
With such extremely negative, underlying dollar fundamentals, near-panic selling and disorderly markets remain a good possibility. Driving relative currency values are relative economic activity, trade balance, inflation, interest rates, government financial conditions and political stability. Each factor, including a U.S. recession, an extreme trade deficit, rising inflation, a Fed "pause," an uncontained fiscal crisis, and low Presidential approval ratings, suggests an atmosphere conducive to the heavy dumping of U.S. dollars.
Most of these negative fundamentals have been in place for some time. Dollar selling, however, has been contained as excess dollar inventories and selling pressures have built to the bursting point. When the dollar selling breaks, and that is just a matter of time, the selling will be massive and the currency movements extreme, despite any central bank intervention aimed at stabilizing the dollar's pace of decline. The currency crisis can break without any further warning. As to a trigger, shocks loom in economic and financial reporting, global political developments and the activities of various central bank.
Generally, the weaker the dollar, the greater will be the ultimate inflation pressure and liquidity squeeze in the U.S. capital markets. As shown in the following graph, the U.S. dollar has continued inching lower in recent months.
[Note: Historical data on both dollar series are available for download on the Alternate Data page of www.shadowstats.com. See the July 2005 SGS for methodology.]
U.S. Dollar Indices. The Shadow Government Statistics' Financial-Weighted U.S. Dollar Index (FWD) is based on dollar exchange rates weighted for respective global currency trading volumes. For December, the monthly dollar average fell by 1.55%, after a 1.66% drop in November. The December 2006 average index level of 50.94 (base month of January 1985 = 100.00) was down 7.57% from December 2005, following an annual rate of decline of 6.70% in November.
Moving in the same direction, December' monthly average of the Federal Reserve's Major Currency Trade-Weighted U.S. Dollar Index (TWD) fell by 0.76% for the month, following November's 1.09% decline. December's level of 58.29 (base month of January 1985 = 100.00) was down 5.63% from the year before, against November's annual decline of 5.73%.
The bigger hit taken recently by the SGS series continues to be due to a much lighter weighting of the Canadian dollar in the FWD versus the TWD. The U.S. dollar has done relatively better against is Canadian counterpart.
Gold -- With the gold price averaging around $630 per troy ounce in December, the precious metal remains poised to strike to new highs in the New Year. While price volatility likely will remain extremely high, the underlying fundamentals in terms of dollar weakness, inflation and political instability all should be boosting the precious metals early in 2007.
As mentioned earlier, market concerns as to the Fed's intentions on inflation and debt monetization increasingly will come into play as the greenback faces heavy selling pressures. Underlying fundamentals easily cold push gold above the $1,000 mark in the year ahead, but its longer term outlook is for much higher prices.
Central manipulation, including talk of central gold sales, will mount rapidly as gold prices rise, occasionally slamming gold investors. Yet, central banks know well that they should be increasing their gold holdings, not liquidating them.
As discussed in previous SGS newsletters, and as will be further detailed in the Hyperinflation Series in the months ahead, the eventual complete collapse of the U.S. dollar -- the world's reserve currency -- will force the creation of a new international currency system. In order to gain public acceptance of a new system, gold is likely to be structured at the heart of it.
The updated gold versus oil and Swiss franc graphs show December averages. As we go to press, gold is trading above $630, oil is over $61 and the Swiss franc is at $0.82. Look for all three measures to trade significantly higher in the first half of 2007.
While election-year political pressures on the statistical system have passed, needs have shifted heavily over to the Federal Reserve in its efforts to prevent a financial-market and financial-system meltdown. Accordingly, upcoming releases of the major series still will be subject to massaging for the perceived needs of the markets. Nonetheless, the reality of the underlying inflationary recession has become increasingly evident in the popularly followed economic series. Against lagging market expectations, though, most near-term economic reporting will continue to surprise the markets on the downside, while most inflation reporting should surprise the markets on the upside.
Employment/Unemployment -- As discussed in the December 11th Flash Update, the BLS reported seasonally-adjusted November payrolls up by 132,000 (134,000 net of revisions) +/- 106,000, following October's revised gain of 79,000 (previously 92,000). Once again, unusual upward revisions were thrown into prior period reporting. On a year-to-year basis, annual payroll growth slowed sharply to 1.3% in November from 1.5% in October.
The November 2006 payroll growth included a 29,000 upside bias provided by the net birth/death model. In November 2005, the bias was 21,000, and that increased to 63,000 in December, suggesting slight upside bias pressure on the December 2006 reporting.
The household survey, which counts the number of people who have a job, as opposed to the number of jobs counted in the payroll survey, reported a seasonally-adjusted employment gain of 277,000. That number that cannot be reconciled with the payroll data.
The unemployment portion of the household data showed the seasonally-adjusted November U.3 unemployment rate at 4.47% +/- 0.2%, up from 4.42% in October. Unadjusted U.3 rose to 4.3% from 4.1%, while the unadjusted broader U.6 measure rose to 7.8% from 7.6%. Adjusted U.6 eased to 8.0% from 8.1%. Including the long-term "discouraged workers" defined away during the Clinton administration, total unemployment remains roughly 12%.
The latest report was against a background of an ongoing collapse of growth in help-wanted advertising, intensifying weakness in new claims for unemployment insurance and weak purchasing managers employment indices (see the respective sections).
Next Release (January 5): While the payroll survey should be weaker than expected in December, the household survey will include annual revisions to seasonal factors related to unemployment reporting. Such allows any level of unemployment that the BLS cares to report.
Gross Domestic Product (GDP) -- The "final" estimate revision of annualized real growth for third-quarter 2006 reflected little more than statistical noise, revising to 1.96% +/- 3% from 2.21% in the "preliminary" estimate, but still up from the initial reporting of 1.58%. Second-quarter growth was 2.56%, where first quarter growth was 5.58%. The growth estimates for the latest two quarters were statistically indistinguishable from contractions, allowing, with increasingly likely revisions, for eventual formal recession reporting with numbers already in place from the Bureau of Economic Analysis (BEA).
In terms of annual growth, the third-quarter's reported pace revised to 2.96% from 3.02% (initially 2.86%), down from 3.51% in the second quarter. Adjusting for methodological distortions built into GDP reporting over time, the SGS Alternate GDP measure suggests economic reality is much weaker, with a year-to-year annual contraction of still roughly 1.5% for the third-quarter GDP, deepening from a 1.0% drop in the second quarter (see the graph in the Alternate Reality section of the Overview -- Opening Comments).
The GDP inflation rate (deflator) in the third quarter remained understated at 1.88%, revised from 1.77% (initially 1.83%), versus 3.30% in the prior quarter, despite annualized seasonally-adjusted CPI in the third-quarter of 2.94% and of 4.97% in the second quarter.
Growth rates in the alternate GDP measures, the broader Gross National Product (GNP) and the theoretically-equivalent Gross Domestic Income (GDI), also were revised. Third-quarter annualized real GNP growth revised to 1.76% from an initial estimate of 1.91%, down from 2.34% in the second quarter. GNP includes trade flows in factor income (interest and dividend payments) and tends to be hurt by the net-debtor status of the United States.
GDI, which is the income-side equivalent of the consumption-driven GDP, grew at a revised annualized real rate of 3.21% (initially 3.43%) in the third quarter, up from a 0.47% contraction in the second quarter.
Next Release (January 31): The "advance" estimate of fourth-quarter 2006 GDP should be weaker than the third-quarter's showing and to the downside of market expectations, despite what surely will be an exaggerated low level of inflation used to deflate the quarterly growth rate.
Consumer Price Index (CPI) -- As discussed in the December 16th Alert, the BLS reported the seasonally-adjusted November CPI-U was unchanged (down 0.15% unadjusted) from October, following October's 0.49% adjusted monthly drop. Of significance, seasonally-adjusted gasoline fell by 1.6%. In conjunction with the retail sales report, this suggests an understatement of gasoline inflation in the CPI by 3.9% in November, and a corresponding overall 0.2% understatement of the CPI, which is about how much the CPI came in below market expectations.
On a year-to-year basis, annual CPI-U inflation (I.6) rose to 1.97% in November from 1.31% in October. The eight levels of annual inflation, I.1 to I.8, are shown in the table in the Alternate Reality section, as is the plot of the SGS Alternate Consumer Inflation number.
The "experimental" Chained Consumer Price Index (C-CPI-U), the fully substitution based CPI that presumably is the eventual replacement for current CPI reporting, showed annual inflation (I.5) of 1.92% in November, up from 1.56% in October. The annual C-CPI-U inflation dropped below that of the CPI-U after two months of topping the popular measure. Nonetheless, the unusual reporting here highlights a problem in the gimmicked CPI-U weightings.
Adjusted to pre-Clinton methodology (I.7), annual CPI growth was about 5.4% in November, up from 4.7% in October. The SGS Alternate Consumer Inflation Measure (I.8), which reverses gimmicked changes to official CPI reporting methodologies of recent decades, was 9.4% in November, up from 8.9% in October.
Next Release (January 18): Inflation has not peaked, but it will take several months into 2007 to regain its recent high annual rates. With seasonally-adjusted CPI-U down by 0.1% in monthly December 2005 CPI reporting, any monthly reporting above that for December 2006 will add directly onto the annual CPI-U inflation rate.
Inflation surprises still should come in on the upside of weak expectations, both for full as well as core numbers. Increasingly reflecting the slow process of oil prices permeating nearly all levels of business activity, upside movement in core rates, in particular, will tend to shock the markets.
Federal Deficit -- As discussed in this month's Reporting/Market Focus, the federal government's fiscal 2006 (fiscal year-end September 30th) deficit, prepared based on generally accepted accounting principles (GAAP), widened to $4.6 trillion from 2005's $3.5 trillion. Such was nearly 19-times the level of the officially-gimmicked 2006 federal budget deficit of $248.2 billion, which was down $70.8 billion from 2005's $318.5 billion.
As a separate measure from the GAAP-based numbers (on an accrual basis) and the official deficit reporting (on a cash basis), the change in gross federal debt is a fair indicator of actual net cash outlays by the government. As of fiscal year-end 2006, the gross federal debt stood at $8.507 trillion, up by $574 billion from 2005, which in turn was up $554 billion from 2004.
For the rolling 12 months through November 2006, the gimmicked deficit was $242.8 billion versus $333.6 in November 2005. As of November 30, 2006, the gross federal debt stood at $8.633 trillion, up by $536 billion from November 2005, which in turn was up $573 billion from November 2004.
Even the official federal deficit should inflate this year, as government finances suffer increasingly from tax revenue losses due to the intensifying recession and relative tax receipt declines after the expiration of recent tax incentives. While GDP growth estimates can be gimmicked, incoming tax receipts (based on consistently applied tax policies) remain an independent estimate of underlying economic reality and eventually will reflect the economy's mounting difficulties.
Initial Claims for Unemployment Insurance -- Annual change in initial claims continued moving into less-negative territory (an economic negative) due to sharp deterioration in recent numbers. New claims averaged over the last eight weeks are up 1.5% from last year, but year-ago comparisons using the 17-week moving average still are distorted by last year's effects of Hurricane Katrina passing through the data. On a smoothed basis for the 17 weeks ended December 23rd, annual change narrowed to a 6.9% decline, from a 7.7% drop as of the November 18th week.
More often than not, week-to-week volatility of the seasonally-adjusted weekly numbers is due to the Labor Department's efforts to seasonally adjust these numbers around holiday periods. The Labor Department has demonstrated an inability to do such adjusting successfully. When the new claims series is viewed in terms of the year-to-year change in the 17-week (four-month) moving average, however, such generally is a fair indicator of current economic activity.
Real Average Weekly Earnings -- Spiked minimally by a 0.2% monthly CPI understatement, November's seasonally-adjusted real earnings rose by 0.2% against October's distorted 1.3% gain. Similarly biased annual growth slowed to 2.6% in November from 3.2% in October.
Variations in the poor quality of reported CPI growth account for most month-to-month volatility in this series. Allowing for the major upside biases built into the CPI-W inflation measure used in deflating the average weekly earnings, annual change in this series continues to signal ongoing severe financial strain on U.S. households and continuing recession.
Retail Sales -- As discussed in the December 16th Alert, the Census Bureau switched to its new sampling for estimating retail sales. On the new basis, seasonally-adjusted November retail sales rose by 1.0% plus or minus a wider error margin of 0.8%, formally 0.7%, and following a revised October decline of 0.1% that had been restated on the new basis to a contraction of 0.4%, against an old basis initial reporting of a 0.2% drop. Of note, gasoline station sales rose by 2.3% from October, suggesting that a like increase in gasoline prices should have been reflected in the November CPI. That did not happen.
When inflation-adjusted year-to-year growth in retail sales falls below 1.8% (using the official CPI-U for deflation), such signals recession. That signal was generated in June 2006. Before inflation adjustment, November growth was up 5.6% from the year before, a 3.6% real growth rate net of the heavily understated annual CPI growth.
Next Release (January 12): December retail sales should come in below expectations, generally reflecting the recession and a less-than-robust holiday shopping season. Inflation-adjusted growth should be negative on a monthly basis, with annual real growth also slowing sharply.
Industrial Production -- As discussed in the December 16th Alert, the Fed went through its annual benchmark revision to industrial production, and found, as it usually does, that production activity in recent years had been weaker than previously reported. Such suggests an eventual downward revision to growth rates of the last several years as currently reported for the GDP.
The seasonally-adjusted 0.2% monthly gain for November industrial production followed a flat October that previously had been up by 0.2%. November annual growth slowed to 3.8%.
Although the manufacturing sector was in contraction, per the November purchasing managers survey, such did not show up in the Fed's survey. Watch out for possible distortions to the December industrial production number from the unusually mild weather in the Northeast.
Next Release (January 17): Look for industrial production to contract in December, reflecting the recession, the purchasing managers survey, and utility usage distortions from unusual December weather patterns. Monthly contractions in this series shortly should become regular.
New Orders for Durable Goods -- The highly volatile durable goods orders rebounded in November by a seasonally-adjusted 1.9% (2.0% net of revisions), after a revised 8.2% (was 8.3%) decline in October. November's orders were up just 0.3% from the year before, a near-recessionary level for a second month.
The widely followed nondefense capital goods orders were down 0.2% in November, following October's 14.8% drop (previously down 15.6%). November's annual growth rate for nondefense capital goods orders was down a recessionary 7.7%.
Durable goods orders lost its status as a solid leading economic indicator when the semi-conductor industry stopped reporting new orders.
Trade Balance -- As discussed in the December 16th Alert, the unbelievable $5.4 billion monthly decline in the seasonally-adjusted October trade deficit to $58.9 billion from September's $64.3 billion was more than accounted for by a plunge in reported oil import prices, without which, the trade deficit would have risen to $64.9 billion. The problem with the report was that accelerated reporting of dropping oil prices for imports already had fully accounted for the recent decline in oil prices.
Of significance to the "advance" estimate of fourth-quarter 2006 GDP, which is commonly reported net of inflation, this deficit "narrowing" due to prices will really be a negative, instead of a positive, for the government's GDP growth estimate.
Next Release (January 10): The November trade deficit should rebound some from October's understatement, rising beyond consensus forecasts. The months ahead will see a pattern of regularly increasing deficits that once again will be setting new records before second-quarter 2007.
Consumer Confidence -- December confidence measures again were mixed. The Conference Board's November consumer confidence -- adjusted by suspect seasonal factors -- rose by 3.5%, after a revised 0.2% increase in November. The unadjusted University of Michigan's consumer sentiment declined by 0.4%, following a 1.6% drop in November.
On a year-to-year basis into November, the damage done to confidence in 2005 by the severe hurricane season largely was responsible for the near-term gains seen in annual growth patterns. On a three-month moving-average basis for December, annual growth in the Conference Board's measure eased to 11.2% from 16.7% in November, while the University of Michigan number was up by 12.2%, versus a 16.5% gain in November. These lagging, not leading, indicators still are suggesting that the economy is in trouble.
Short-Term Credit Measures -- Annual growth in consumer credit showed some problems, particularly against the backdrop of what was the beginning of the holiday shopping season. Short-term commercial credit measures, however, remained strong, holding double-digit percentage annual growth.
Growth in seasonally-adjusted consumer credit declined by 0.1% for the month of October, with annual growth easing to 4.2%, from a revised 4.3% (was 3.7%) in September. Without real (inflation-adjusted) growth in personal income, growth in the real personal consumption component of GDP cannot be supported, except by debt expansion or savings liquidation. Consumer debt expansion, though increasing on an annual basis, has stalled on a monthly basis, suggesting a serious constraint on economic growth.
Annual growth in commercial paper outstanding remained strong in November at 17.8%, up from October's 17.6%. Annual growth in commercial and industrial loans slowed slightly to 15.0% in November from a revised 15.4% (was 14.9%) in October. Strong growth in the commercial credit measures can signal credit needs tied either to rising sales and receivables/inventory needs, or to slowing sales and slowing collections and involuntarily rising inventories.
Producer Price Index (PPI) -- Running somewhat counter to the serious understatement of monthly CPI inflation, the seasonally-adjusted November finished goods PPI jumped by 2.0% (0.8% unadjusted). At work appears to be a much needed catch up in the annual seasonal distortions (adjustments) published by the BLS. November's increase offset October's 1.6% monthly decline (down 1.2% unadjusted), but still was shy of recovering levels seen before September's 1.3% drop (down by 1.1% unadjusted). November's annual PPI inflation rebounded to a gain of 0.9% following October's 1.6% contraction. Seasonally-adjusted November intermediate goods rose by 0.7% for the month, while crude goods exploded by 15.7%.
Next Release (January 17): Despite the large component of random volatility in monthly price variations, PPI inflation reporting over the next six-to-nine months generally will exceed still-depressed expectations. December reporting, should continue a general upside trend in monthly and annual PPI reporting. Core inflation also should resume offering upside surprises to consensus forecasts, despite the increasingly poor quality of reporting.
The following numbers are generally good-quality leading indicators of economic activity and inflation that offer an alternative to the politically-hyped numbers when the economy really is not so perfect. In some instances, using a three-month moving average improves the quality of the economic signal and is so noted in the text.
Economic Indicators
Purchasing Managers Survey: Manufacturing New Orders -- The key November index components fell to outright contraction levels (below 50.0) for the first time since 2003. For example, November new orders fell 6.5% to 48.7 from 52.1 in October. As an SGS early warning indicator of a pending major economic shift, the new orders measure breached its fail-safe point in mid-2005, generating a signal of pending recession.
Distortions from suspect seasonal-adjustment factors from the Commerce Department are overcome by viewing the series using year-to-year change on a three-month moving average basis. On that basis, the November new orders index fell by 13.7% following October's 9.0% contraction. The index gradually has notched lower from its peak annual growth of 42.6% in April of 2004.
Published by the Institute for Supply Management (ISM), the new orders component of the purchasing managers survey is a particularly valuable indicator of economic activity. The index is a diffusion index, where a reading below 50.0 indicates contracting new orders.
Moving in tandem with new orders, production and employment, the overall November ISM manufacturing index dropped to 49.5 from October's 51.2. An index level below 50.0 indicates a contracting manufacturing sector. The November employment component moved to 49.2 from October's 50.6 reading.
The service-sector ISM index does not have much meaning related to overall business activity, since new order activity at law firms, hospitals or fast-food restaurants have little obvious relationship to broad economic activity. That said, the overall November services index rose to 58.9 from October's level of 57.1.
Both the services employment and prices paid components, however, have some meaning. The November employment component notched higher to 51.6 from 51.0 from 53.6 in October. The prices paid component is covered in the Inflation Indicators.
Help-Wanted Advertising Index (HWA) -- The November help-wanted advertising index held at 30, the same as in October, but September's initial reading of 30 revised to 29, the lowest level seen since Sputnik was first orbiting Earth.
The series indicates rapidly deteriorating employment conditions. While the index never recovered from the 2000 recession, its recent, deepening plunge -- annual change is down 21.3% on a three-month moving average basis -- signals a renewed and rapid contraction in economic activity.
Housing Starts -- Although seasonally-adjusted November housing starts rose by 6.7% +/- 10.1% for the month, annual change plunged by 25.5%, following October's 27.3% decline. The annual change on a three-month moving-average basis has declined to a year-to-year drop of 24.3%, the worst reading since the depths of the 1990/1991 recession. Such continued to generate an intensifying recession signal.
In related data, respective rates of annual contraction for November new- and existing-home sales were 15.3% and 10.5%. Although the annual rates of change were less negative than in October, the indicated activity remained consistent with a sharp economic downturn.
Money Supply -- Annual growth in M3 accelerated to 10.8% in December, up from an upwardly revised 10.4% in November. The increasing upturn in M3 growth would be enough to begin tickling inflation concerns in the financial markets, if only the Fed were still reporting M3. The reported M3 growth is per the SGS Continuing M3 Series reporting, with December's number estimated on three weeks of data. The upward revision to November's initial annual growth estimate of 10.1% reflected upward revisions to Federal Reserve reporting of M2 and large time deposits at commercial banks.
[Note: Historical annual growth data for the money supply series, including the ongoing SGS estimates of M3, are available for download on the Alternate Data page of www.shadowstats.com. See the August 2006 SGS for methodology.]
The December data are based on three weeks of data for the month. Before inflation adjustment, monthly seasonally-adjusted December M1 and M2 respectively fell an estimated 0.9% and rose by 0.5%, after a respective 0.5% decline and 0.5% increase in November, and 0.8% and 0.9% gains in October. Month-to-month M3 change was approximately 1.1% for December and 1.0% in November.
Annual growth in December for monthly M1 fell by 1.0%, versus a 0.5% contraction in November, while annual M2 growth rose held at 5.1%. Net of still-distorted annual CPI inflation, real annual growth rates for December M1 and M2 remained consistent with the ongoing recession, with December's M1 and M2 year-to-year rates of change down by roughly 3.1% and up 2.9%, respectively. On a three-month moving-average basis, the December inflation-adjusted annual rates of change were down 2.4% and up 3.1%, levels that still were underwater using the old-style CPI.
Inflation Indicators
Purchasing Managers Surveys: Prices Paid Indices -- In line with surging PPI reporting, but counter to the soft monthly data on the CPI, the pricing components of both purchasing managers surveys rose sharply. On the manufacturing side, the November prices paid diffusion index jumped 13.8% to a reading of 53.5 from October's 47.0. On a three-month moving average basis, November's annual change was down by 30.0% versus October's 19.4% contraction.
On the non-manufacturing side, the November prices diffusion index rose 7.1% to 55.6 from 51.9 in October. On a three-month moving average basis, November's annual change was down by 29.6% against October's annual 17.6% decline.
Published by the Institute for Supply Management (ISM), the prices paid components of the purchasing managers surveys are reliable leading indicators of inflationary pressure. The measures are diffusion indices, where a reading above 50.0 indicates rising inflation.
Oil Prices -- The monthly-average West Texas Intermediate Spot (St. Louis Fed) rose to $59.37 per barrel in November, up 0.8% from October's $58.88. The November average was up 1.8% from the year before, against October's annual 5.6% rate of decline. Oil generally traded above $60.00 per barrel in December, with the nearby contract closing at $61.05 on Friday. The December monthly average will be up both on month-to-month and year-to-year bases.
Spot oil prices will continue to gyrate, but generally will move higher in the year ahead. Such reflects OPEC manipulations aimed at price support and Middle East tensions that are mounting anew, now that the election has passed. Further, gone are annual price change comparisons against the market distortions of a year ago from the devastating 2005 hurricane season.
Also in play is the dollar-based pricing of oil. U.S. Dollar weakness is the equivalent of an oil price cut for oil purchasers denominated in an appreciating currency. Market forces tend to balance out such matters by pushing dollar-based oil prices higher. Even worse for the U.S. markets, though, is the developing trend of pricing oil in something other than dollars. Where Iran has moved to euro pricing, other OPEC members will not be far behind if the dollar faces heavy selling in the New Year.
Despite recent extreme volatility, oil prices will remain at highly inflationary levels and will continue as a major contributing factor to the United States' inflation problems. The historically high oil prices still are working their way through all levels of U.S. economic activity, ranging from transportation and energy costs, to material costs in the plastics, pharmaceutical, fertilizer, chemical industries, etc. Cost pressures already have only just started to show up in the so-called "core" inflation measures. Again, these broad inflationary pressures will remain intact despite any near-term oil price volatility.
Please note that while downside oil price movements are picked up more quickly and fully by the BLS in its inflation measures than are upside movements, the general trend in both CPI and PPI reporting -- at both the aggregate and core levels -- will be to the upside at least through mid-2007.
The coverage and available prior material are detailed below for various series. Data reported with a less-than-monthly frequency also are updated here or in the Reporting/Market Focus.
Quarterly/Annual Reporting -- Most series analyzed are published on a monthly or weekly basis. Followed economic/market series that are published with less-than-monthly frequency include:
Annual:
* Financial Statements of the United States Government (see the Supplement to December 2005 SGS; latest analysis is the SGS Alert of December 16, 2006 and the current Market/Reporting Focus for the December 2006 SGS).
* Income Variance/Dispersion (most recent analysis was is in the September 2006 SGS; next analysis is due September 2007).
Quarterly:
* Flow of Funds Accounts of the United States (the most recent analysis was in the October 2006 SGS; the next analysis is due in the January 2007 SGS).
Reporting/Market Foci -- The various economic and financial-market series are being addressed in a monthly "Reporting/Market Focus," with this month's analysis covering the 2006 GAAP-based financial statements of the U.S. Government. Employment, GDP, CPI and the Federal Deficit separately are explored in the background article "A Primer on Government Economic Reports," available on the Home page of www.shadowstats.com.
The series detailed so far in the Reporting Foci or background articles are listed below. The referenced SGS publications are available on the Archives page of www.shadowstats.com.
* Consumer Confidence (November 2004 SGS).
* Consumer Price Index (an original background article [updated October 2006], October 2005 SGS, alternate numbers introduced August 2006 SGS).
* Credit Measures, Short-Term (August 2005 SGS).
* Durable Goods, New Orders for (May 2006 SGS).
* Employment/Unemployment (an original background article, alternate measures (April 2005 SGS).
* Federal Deficit (an original background article, update in the Alert of July 7, 2005, update in Supplement to December 2005 SGS, update in Alert of December 16, 2006 and the December 2006 SGS).
* Gross Domestic Product (an original background article, alternate numbers introduced August 2006).
* Help Wanted Advertising (January 2006 SGS).
* Housing Starts and related housing statistics (June 2006 SGS, November 2006).
* Income Variance/Dispersion (September 2005 SGS, September 2006 SGS).
* Industrial Production (January 2005 SGS).
* Money Supply (Part I / SGS Early Warning System - May 2005 SGS, Part II - June 2005 SGS, M3 update November 2005 Supplement, M2 update March 2006 SGS, M3 continuing series introduced August 2006).
* Producer Price Index (April 2006 SGS).
* Productivity (October 2006 SGS).
* Purchasing Managers Survey (February 2006 SGS).
* Retail Sales (March 2005 SGS).
* SGS Early Warning System (May 2005 SGS, June 2005 SGS).
* Trade Balance (December 2004 SGS).
* Unemployment Insurance, Initial Claims for (February 2005 SGS).
* U.S. Dollar Indices, Financial- and Trade-Weighted (July 2005 SGS).
The text of the December 16, 2006 Alert related to the government's GAAP-based 2006 financial statements is repeated below. The following paragraph is added for clarification purposes:
The U.S. Treasury heavily reported the rapidly increasing shortfalls in the unfunded liabilities for Social Security and Medicare in its financial statements, but referred to the liabilities as off balance sheet. The actual $4.6 trillion deficit for 2006 is calculated with those numbers on balance sheet, as the year-to-year change in the negative net worth of the federal government shown in the table below.
That accounting is what a U.S. corporation would have to show. The Administration's rationale as to why Social Security and Medicare should remain off balance sheet runs along the lines that the government always has the option of changing the Social Security and Medicare programs. That said, there clearly is no one in political Washington willing to go public with the concept of eliminating or substantially cutting those programs.
December 16th Alert on the 2006 Financial Statement of the United States Government:
Yesterday, the U.S. Treasury published its annual generally-accepted-accounting-principles (GAAP) basis financial statement, signed off on by Treasury Secretary Henry M. Paulson, Jr. The consolidated statements show that the actual annual federal deficit for fiscal year ended September 30, 2006 was $4.6 trillion, up from $3.5 trillion in 2005. Total federal obligations at year-end were $54.6 trillion, up from $50.0 trillion in 2005.
The actual deficit number was nearly 19-times the size of the gimmicked "official" deficit for 2006 of $248 billion. Total obligations were 4.2-times annual U.S. GDP.
The above GAAP numbers include accounting for the year-to-year change in the net present value of unfunded liabilities in social insurance programs such as Social Security and Medicare. The Treasury notes that these liabilities are "not considered liabilities on the balance sheet." While Treasury has pushed for such an accounting standard for the federal government, it would not have a choice as to reporting these obligations if it were a corporation such as General Motors.
Net of the obligations for Social Security and Medicare, the GAAP-based deficit narrowed to $450 billion in 2006 from $760 billion 2005. Such is not credible give the bookkeeping for Katrina relief and the Iraq War. While these numbers likely involve some accounting shenanigans -- as did the last reported annual deficit decline in the 2004 -- the method is not obvious given a quick review of the 172-page document. The issue will be looked at more closely in the December SGS. Nonetheless the published estimates are roughly double the "official" deficits reported for 2005 and 2006.
The 2006 GAAP statement can be found on the Treasury's Web site, under Financial Management Services at: http://www.fms.treas.gov/fr/index.html
-----------------------------------------------------------------------
U.S. Government - Alternate Fiscal Deficit and Debt
Reported by U.S. Treasury
Dollars are either billions or trillions, as indicated.
Sources: U.S. Treasury, Shadow Government Statistics.
-----------------------------------------------------------------------
Formal GAAP GAAP GAAP Total
Cash- Ex-SS With SS Federal Gross Federal
Fiscal Based Etc. Etc. Negative Federal Obligations
Year* Deficit Deficit Deficit Net Worth Debt (GAAP)
-----------------------------------------------------------------------
($Bil) ($Bil) ($Tril) ($Tril) ($Tril) ($Tril)
------ ------ ------ ------ ------ ------
2006 $247.7 $449.5 $ 4.6 $53.1 $8.5 $54.6
2005 318.5 760.3r 3.5 48.5r 7.9 50.0r
2004 412.3 615.6 11.0r** 45.0r 7.4 46.4r
2003 374.8 667.6 3.0r 34.0r 6.8 36.2
2002 157.8 364.5 1.5 31.0r 6.2 32.7
-----------------------------------------------------------------------
* Fiscal year ended September 30th.
** Estimated at $3.4 trillion, excluding one-time unfunded setup
costs of the Medicare Prescription Drug, Improvement, and
Modernization Act of 2003 (enacted December 2003).
r - Revised prior-period data as shown in the 2006 Report.
-----------------------------------------------------------------------
The GAAP numbers in the above table are derived from or published in the tables on pages 3, 6 and 13 of the Report,
As usual, the Government Accountability Office (GAO) -- formerly the General Accounting Office -- would not certify the statement, due to "material weaknesses in financial reporting" (page 27). The GAO, which uses a less expensive definition (on an open versus closed group basis) than the Treasury in its Social Security and Medicare numbers, noted (page 28): "that the Federal government's fiscal exposures total approximately $50 trillion as of September 20, 2006, an increase of about $4 trillion over September 30, 2005, and up from about $20 trillion as of September 30, 2000.
As noted in SGS analyses of prior years' statements, the current GAAP-based deficit is beyond containment in the present environment. Severe political constraints limit any meaningful reduction of the Social Security and Medicare programs, while addressing the issue with taxes is impossible. If federal income taxes were adjusted to as to seize 100% of all salaries and wages earned in the United States, the government's operations still would be in deficit. Contrary to the suggestion of Treasury Secretary Paulson, the United States cannot grow its way out this shortfall. The problem is out of control.
Questionable statistical practices at the Board of Governors of the Federal Reserve System go well beyond the elimination of M3 reporting. Unusual patterns and revisions are showing up in the Fed's Flow of Funds Accounts that show the sources and uses of cash and credit within the U.S. financial system and economy. These anomalies are explored.
January's "Shadow Government Statistics" newsletter is targeted for release near the end of the month. Its posting on the Web site, as well as all interim Flash Updates and Alerts, will be advised immediately by e-mail.