JOHN WILLIAMS' SHADOW GOVERNMENT STATISTICS


Issue Number 10


August 10, 2005

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A Return to Clinton-Era Manipulations?


CPI Should Surge in July, as Inflationary
Recession Takes Increasing Hold


No Matter How Well Cooked the Books Are,
Markets Still Face Data Shocks

A number of key economic indicators ran counter to our forecasts last month, particularly July employment. Nonetheless, the broad economic outlook has not changed, and the 2005-2007 inflationary recession continues to unfold.

Instead of the predicted outright contraction, July payrolls jumped by 207,000, the strongest monthly gain since April. What happened with the employment, CPI and trade numbers is discussed in each respective section. In the case of payrolls, consistent application of seasonal adjustments would have shown a jobs gain of 44,000, still not a contraction.

As suggested in the July 14th Alert "June CPI Hanky-Panky," more than poor quality reporting may be at work in current government statistical releases. Occasionally, government calculations of seasonal factors can suffer an across-the-board major distortion that will throw off monthly results for a month or two. Such appeared to be the case in April. This remains a possibility for June, given the number of series where seasonal-factor distortions helped skew reported results. Seasonal-factor rigging, however, also has been used historically as a tool for near-term political manipulation of data.

Given flagging presidential ratings, a more likely explanation than accidentally-warped seasonals for too-good data is that the Bush administration has moved into a direct, monthly political-manipulation mode, much as was seen during the better part of the Clinton administration. Another month of reporting should answer that possibility beyond a reasonable doubt.

As background as to how our monthly analyses work, estimates of upcoming economic reporting are based on either standard or political analysis. If political analysis is the basis of a forecast, such is noted in the accompanying text. The two approaches are as follows:

(1) Standard analysis combines the results of our models of underlying business conditions -- based on the more-reliable leading indicators of economic activity -- with known reporting biases and any other known current irregularities in the data. Such analysis has worked reasonably well in explaining economic reporting from the Bush administration, until recently.

(2) Political analysis reviews the standard analysis but relies heavily on an assessment of the economic reporting result the current administration perceives will give it political support, balanced against what is perceived by the administration as needed to keep the financial markets stable and positive. This approach worked very well in explaining economic reporting during much of the Clinton administration, the most masterful manipulators seen in the history of modern U.S. economic reporting.

For example, during the Clinton administration, reporting of payroll growth had been targeted at three million new jobs per year, 250,000 jobs per month. For an extended period of time, the reported monthly changes -- usually after allowing for monthly revisions -- came out at exactly 250,000 per month, or exactly 500,000 for two months. What the obvious process indicated was that the seasonally adjusted numbers were being set, and the supposedly raw, unadjusted data were backed into. The practice continued until we called them on it. At least they stopped using exact increments of 250,000. The issue received minor press. Some other creative data tactics used in the 1990s have been described in the background articles available on the home page, but the statistical hanky panky was not limited to the Clinton administration.

When the first President Bush was facing his difficult reelection bid, a senior Commerce Department official met with the head of major corporation and asked that computer sales be overstated in reporting to the Bureau of Economic Analysis. The request was honored and reported GDP growth was spiked artificially. That story came from a participant in the original meeting and has been confirmed separately by an official at the BEA. As an aside, the involved corporation has been a major sponsor of the Conference Board.

Not only does a non-recession outlook help the current Bush administration, in theory, it also is a big plus to Wall Street, where financial pressures and resulting potential conflicts of interest often impact the way the economic environment is presented to the public. That brings us to the bizarre timing of the Conference Board in revamping the index of leading economic indicators (LEI) last month.

Once published by the government, the LEI was widely followed as a signal of pending economic activity. When the government moved to privatize the series in 1995 -- during the Clinton administration -- the Conference Board won the bidding.

Economic series occasionally get redefined. When the effort is to improve accuracy, that is one matter. Overhauling a series when it is signaling imminent recession and changing the signal to one of healthy economic growth is another. By redefining its series, the Conference Board accomplished the latter. Such is reasonably consistent with the government's approach to changes in statistical reporting methodologies. The final product usually ends up enhancing reported economic growth or reducing the rate of reported inflation.

The traditional recession signal from the LEI was generated by three consecutive month-to-month contractions. While such a signal sometimes proved to be false, usually the economy at least slowed. Prior to the current overhaul, the LEI had contracted for the last three months, through May, and had fallen in nine of the last 12 months. As of the June restatement, the LEI now has risen in each of the last three months.

The Conference Board's primary mission is to "help businesses strengthen their performance." Apparently, reporting bad economic news has not always been part of that mission. The late Al Sindlinger often told the story of his early days, as an outsider under contract, in setting up and running the Conference Board's Consumer Confidence Index. It seems that whenever he reported a gain in confidence, he would hear the news shortly thereafter on the radio. Whenever he reported a decline in confidence, he always would get a call asking him to recheck his numbers, with the clear message that a positive result was desired.

There are limits to manipulation, however, ranging from what even the most gullible analysts cannot swallow, to reporting of corporate profits and tax receipts. Also, standard economic series, either from the private sector, such as the Conference Board's help-wanted advertising index, or less followed series, such as real average weekly earnings, often remain free of undue outside influence. Therein lie the potential data shocks for the markets.

As an example, the unchanged June CPI pushed reporting to the brink of rousing the gullible. Accordingly, anything but a hefty July CPI gain is going to have serious credibility problems.

A number of inflation measures, such as those seen in the purchasing managers survey, are suffering shock on a year-to-year basis against last year's extremely strong inflation indicators. Those extraordinary comparisons will pass after August. Distortions from extremes of weather and unusual seasonal factors tend to reverse in a matter of a month or two. As an example, look for a fair tumble in August industrial production, as will be reported in mid-September.

In general, the recent happy economic reports out of Washington are offering statistical misguidance, whether deliberate or accidental; underlying economic reality has not shifted. Recession, inflation and dollar problems are imminent and do not offer a positive environment for the financial markets. With minor changes, here is a recapitulation of recent points as to the broad picture of what lies ahead:

The Shadow Government Statistics' Early Warning System was activated in May and continues to signal the onset of a formal recession early in third-quarter 2005.

The system looks at historical growth patterns of key leading economic indicators in advance of major economic booms and busts and sets growth trigger points that generate warnings of major upturns or downturns when predetermined growth limits are breached. Since the beginning of 2005 a number of key indicators have been nearing or at their fail-safe points. In the last several months, three indicators moved below those levels, signaling an imminent recession. Once beyond their fail-safe points, these indicators have not sent out false alarms, either for an economic boom or bust.

While sporadic, negative GDP growth likely will not surface in government reporting until later in 2005 or 2006. The National Bureau of Economic Research (NBER) should time the downturn to mid-2005 and announce same sometime in early-to-mid 2006. The popular financial media will begin to debate whether there is a recession underway by late 2005, but those Wall Street economists who act as shills for the market will keep up their "strong growth is just around the corner" hype regardless of any and all evidence to the contrary.

From the standpoint of common experience, this downturn will be considered the second leg of a double-dip recession, not an independent contraction as will be claimed officially.

Despite recent gains in key series, most economic data already have started to soften, and the trend will accelerate sharply, with monthly contractions beginning for payroll employment and industrial production in the near future. Political manipulation, if used, can keep the payroll data afloat for a while longer. Significant deterioration also will be seen in federal tax receipts (a widening budget deficit) and corporate profits. This outlook is predicated on economic activity that already has taken place and does not consider any risks from exogenous factors such as renewed terrorist activity in the United States.

Market perceptions will be slow to adjust to the renewed downturn in business activity. When expectations finally begin to anticipate weak data, expectations also will be lowered for inflation. As a result, consensus forecasts generally will tend to continue to be surprised on the downside for economic reports, and on the upside for inflation reports, for some time to come.

The roots of the current difficulties are structural in nature. A consumer starved of income growth and overburdened with debt cannot sustain the real (inflation-adjusted) growth in consumption needed to keep GDP growth in positive territory. The income weakness is a direct result of the loss of a significant manufacturing base to offshore locations and the ensuing explosive, perpetual growth of the U.S. trade deficit.

Exacerbating economic and financial woes will be unusually high inflation during this contraction. Inflation, fueled by high oil prices and weakness in the U.S. dollar, will not be brought under control simply by weakness in economic demand. Instead, persistently high prices only will serve to intensify the 2005-2007 recession, making it unusually long and protracted. Ongoing inflation woes and dollar problems will maintain upside pressure on long-term interest rates, inhibiting the traditional flattening of the yield curve expected with a recession.

An inflationary recession remains a nightmare for the financial markets. Particularly hard hit will be the U.S. dollar, with downside implications for both equity and bond prices.


THE BIG THREE MARKET MOVERS

(Each of these series is explored in the background article "A Primer On Government Economic Reports," available on the home page.)

Employment/Unemployment -- July's relatively strong reported payroll numbers reflected unusually distorted seasonal factors, but met the political needs of the administration. In theory, seasonal factors distorted in one direction eventually have an offset within a given year's adjustments. Such no longer is the case with the jobs data, since the Bureau of Labor Statistics has been calculating anew and revising monthly seasonal adjustments, each month, as it goes along. July was the second consecutive month of upside seasonal distortion, the third such result in the last four months. The current seasonal deviations are detailed below.

Separately, last month saw the publication of a public policy brief from the Federal Reserve Bank of Boston that was suggestive of an increase in long-term discouraged workers since the onset of the 2001 recession. Those workers have not been counted officially since a methodology shift during the Clinton administration. The article by Senior Economist Katharine Bradbury, "Additional Slack in the Economy: The Poor Recovery in Labor Force Participation During This Business Cycle," shows that the portion of the population participating in the labor force in the current economic "recovery" is significantly below that of the last five business cycles, except for those 55 and older. There, participation is higher than normal.

Ms. Bradbury's study suggests that since May 2001, an added 1.6 million unemployed individuals may have slipped off the Bureau of Labor Statistics radar screen, a number that could show up in the pending annual poverty survey. As to the increased participation of workers who are 55 years old or older, the story there likely is tied to diminished comfortable-retirement prospects that have resulted from unstable financial markets and less-than-positive economic activity.

Getting back to the current surveys of labor conditions, the popularly followed unemployment rate U-3 for July 2005 was 5.01%, seasonally adjusted, virtually unchanged against June's 5.02%. Unadjusted U-3 unemployment held at 5.2% in July, while the broader U-6 unemployment measure backed off from June's 9.3% to 9.1%. The seasonally-adjusted U-6 rate notched lower from 9.0% to 8.9%. Including the long-term "discouraged workers" defined away during the Clinton administration, total unemployment remained roughly 12%, perhaps 13%, given the results suggested by the Boston Fed article.

The household survey showed a seasonally-adjusted 438,000 gain in July employment after June's 163,000 increase in the number of people who were gainfully employed.

Moving in tandem with household employment, the June payroll survey showed a seasonally-adjusted gain of 207,000 (249,000 net of revisions) +/- 108,000, after June's initial reporting of 146,000 new jobs was revised upward to 166,000.

The July gain was despite a negative bias factor that subtracted 76,000 jobs from the underlying unadjusted data (80,000 jobs were subtracted last July). In August, the fudge factor swings back to the plus side, where it added 123,000 jobs to last August's payroll reporting.

Once again, patterns of year-to-year growth in the payroll series have been highly irregular and highlight unconscionable games being played with the month-to-month seasonal factors. On an unadjusted basis (which is the statistically better way to view the annual changes), annual growth was 1.66% in June, 1.63% in July. Seasonally adjusted, the slightly declining unadjusted annual growth swings to an increase, with June annual growth of 1.59% surging to July's 1.69%. Properly adjusted for seasonal factors, the annual growth rates should be within a point or two, each month, to the second decimal point. Reported on an adjusted basis that is consistent with the unadjusted annual growth, July payrolls would have risen by 44,000, some 163,000 jobs less than the official estimate.

July's employment/unemployment data were against a background of still-weak help-wanted advertising, an increase in employment as reported in the July manufacturing purchasing managers surveys, and a monthly improvement in new claims for unemployment insurance (see the respective sections).

Next Release (September 2): August payrolls will get a boost from a roughly 200,000 jobs positive swing in the monthly bias factors. On the downside is the impact of the unfolding recession and a chance of some reversal in distorted seasonal factors. Given the chance that reporting has moved to a political-manipulation mode, odds have to favor a relatively strong report. Underlying fundamentals, though, continue to favor declining payrolls and rising unemployment.

Gross Domestic Product (GDP) -- The annual benchmark revisions were in the right direction, showing weaker growth and higher inflation than previously reported, in line with our expectations. Still, GDP growth remained significantly overstated, reconfirming the GDP's status as the most worthless and overrated of the major economic reports.

Real growth was revised downward for the affected years, with growth in 2002 revising from 1.9% to 1.6%, 2003 from 3.0% to 2.7% and 2004 from 4.4% to 4.2%. Partially accounting for the slower real growth, GDP inflation revised upwards, with inflation in 2002 holding at 1.7%, 2003 rising from 1.8% to 2.0% and 2004 rising from 2.2 to 2.6%.

As shown in the two accompanying graphs, the downward revisions in growth were noticeable but did not change the broad growth patterns meaningfully. Since the revisions only went as far back as 2002, there was no chance of the 2001 recession being reinstated, but the much softer quarterly growth now reported for fourth-quarter 2002 suggests the economic downturn lasted longer than officially recognized.






Based on our analysis of manipulative methodological changes to the GDP over time, year-to-year or annual growth in reported GDP remains overstated by about three percent. As shown in the graph of year-to-year growth, the official pattern of slowing annual growth since first-quarter 2004 is really more a pattern of stagnation, with annual growth hovering just above zero for the last several quarters.

GDP accounting is akin to double-entry bookkeeping, where the consumption components of GDP are offset dollar-for-dollar in the income components of Gross Domestic Income (GDI). While the two measures should be equal, in theory, they rarely are, and any difference is thrown into the statistical discrepancy category.

The discrepancy revision was large, swinging from GDI suggesting that GDP was understating growth to suggesting that GDP was overstating growth. What had been a negative statistical discrepancy of $95.8 billion in nominal first-quarter 2005 GDP/GDI reversed to a positive $21.3 billion in revision. This meant that GDI growth revised downward by a full percent more than did the GDP.

The "advance" estimate of second-quarter 2005 annualized real GDP growth was reported at 3.41% +/- 3.1%, down from the 3.80% growth in the first quarter. The reported growth still is hardly statistically distinguishable from zero growth. Year-to-year real growth in the second quarter held at 3.62% versus 3.64% in the first quarter.

Next Release (August 31): The "preliminary" estimate revision will depend largely on the June trade deficit. If the deficit widens sharply, as we believe it will, second-quarter GDP growth will be in for some downward revision.

Consumer Price Index (CPI) -- The seasonally-adjusted June CPI-U was unchanged (+0.1% unadjusted) and continued offering a false peace to the financial markets, after May's adjusted 0.1% decline. Still going against strong inflation last year, unadjusted June year-to-year inflation fell to 2.53% from 2.80% in May.

Once again, the CPI appears to have been reduced through the use of reporting artificially low energy prices, as highlighted in the July 14th Alert:

"Here's where the hanky-panky comes in. Consider, for example, that official (CPI) seasonally-adjusted gasoline prices declined 1.2% in June after a 4.4% plunge in May. Further June 2005 gasoline prices were up just 6.9% from June 2004. The reported gasoline inflation rates, however, are demonstrably shy of reality. One good surrogate for seasonally-adjusted changes in gasoline prices is seasonally-adjusted retail sales of gas stations.

"...Instead of down 1.2% for June, retail gasoline sales were up 1.9%; instead of down 4.4% in May, sales were down just 0.5% (revised from a 1.6% drop); instead of up 6.9% year-to-year, gasoline sales were up 16.2%!

"...Accepting, for the moment, that the retail gasoline sales numbers were more accurate than the Bureau of Labor Statistics (BLS) reporting, corrections to just the gasoline price measure in the CPI would have added 0.3% to the combined CPI changes of May and June, and the cumulative effect of catching up on year-to-year change would have boosted annual inflation to 2.9% from today's 2.5%. ..."

As a point of clarification, changes in gasoline retail sales are dominated by price changes in gasoline. Seasonally-adjusted volume changes tend to be small, and the above alternate CPI pricing calculations backed out the impact of an estimated annual 2.5% growth in physical gasoline consumption included in the retail sales data.

Using the CPI's original (pre-Clinton Era) methodological approach of a fixed basket of goods (vs. substitution of hamburgers for steak as estimated by geometric weighting) would leave year-to-year inflation at about 5.3% instead of the official 2.5%.

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 at 2.17% in June, down from May's 2.54%.

Next Release (August 16): Inflation pressures continue, despite promises of Alan Greenspan to the contrary, and an sharp upside movement to July CPI is likely, higher than consensus forecasts of about 0.4%. Gasoline alone should add 0.6% to the monthly rate, if the CPI catches up with prices reported by the Energy Information Administration. Such is a big "if" at present.

If energy costs do not show a significant pick-up in July, the chorus of those suspecting some hanky-panky at the BLS will grow quickly. High oil prices assure an eventual rebound in reported CPI inflation to levels well above the near-term annual inflation peak of 3.5% in April. Any seasonally-adjusted monthly change above or below a 0.1% decline July should add directly to or subtract from the currently reported annual growth of 2.5%.


OTHER TROUBLED KEY SERIES

To varying degrees, the following series have significant reporting problems. All series (including the more trouble free) will be addressed in a monthly "Reporting Focus," with Short-Term Credit Measures covered this month. In addition to the big three, other series that have been detailed are The Federal Deficit (an original background article and an update in the Alert of July 7, 2005), Consumer Confidence (November 2004 SGS), the Trade Balance (December 2004 SGS), Industrial Production (January 2005 SGS), Initial Claims for Unemployment Insurance (February 2005 SGS), Retail Sales (March 2005 SGS), Alternate Payroll Employment Measures (April 2005 SGS), Money Supply - Part I / SGS Early Warning System (May 2005 SGS), Money Supply - Part II (June 2005 SGS), Financial- and Trade-Weighted U.S. Dollar Indices (July 2005 SGS).

Federal Deficit -- The official deficit for the fiscal year ended September 30, 2004 was $412.3 billion, up from $374.8 billion the year before. For the twelve months ended June 2005, the rolling deficit was $335.5 billion versus $431.1 billion in June 2004.

Gross federal debt as of the end of September (U.S. fiscal year-end 2004) was $7.379 trillion, up $596 billion from a year earlier; at month-end July 2005, gross federal debt was $7.888 trillion, up $571 billion from July 2005, which, in turn, was up by $565 billion from July 2003.

The deficit outlook will turn quickly and sharply to deterioration as the recession sets in, and the Treasury's borrowing needs will tend to exceed expectations. Accordingly, it was not surprising that the 30-year Treasury bond was reintroduced for the coming year's fundings.

Initial Claims for Unemployment Insurance -- The annual change for new claims on a smoothed basis, for the 17 weeks ended July 30th widened to a decline of 5.5% versus a 3.9% versus drop as of July 2nd. The moving average, accordingly, has backed off a month from a string of continual deterioration and from turning positive (a negative economic development), which would support signals of a recession onset.

The volatility of the seasonally-adjusted weekly numbers is due partially to the seasonal-adjustment process. When the series is viewed in terms of the year-to-year change in the 17-week (three-month) moving average, however, such is a fair indicator of current economic activity.

Real Average Weekly Earnings -- June's seasonally-adjusted real average weekly earnings gained 0.2% from May, after May's change was revised from a gain of 0.3% to the negative side of flat. June's gain, like May's was overstated by artificially low CPI inflation that should show some reversal in July (see CPI section). June's reported real earnings rose 0.4% from the year before, while May's previously reported 0.3% annual contraction revised to a 0.1% decline.

Allowing for the biases built into the CPI-W series used to deflate the weekly earnings, annual change in this series continues to signal a recession warning.

Retail Sales -- Seasonally-adjusted June retail sales jumped by 1.7% (2.1% net of revisions) +/- 0.7%, following revised May's 0.3% decline (originally a 0.5% drop). On a year-to-year basis, June retail sales were up 9.6% versus a 6.4% increase in May (previously 6.8%).

Inflation-adjusted growth in retail sales below 1.8% (using the official CPI-U for deflation) signals recession, and annual growth remained comfortably above that level in June reporting.

Next Release (August 14): July retail sales likely will come in below strong expectations, mirroring a combination of impaired economic activity and sales volume puffed by rising consumer prices.

Industrial Production -- Most of the 0.9% gain in June's seasonally-adjusted industrial production derived from unseasonably hot weather and a 5.3% monthly surge in seasonally adjusted utility usage; May's previously reported 0.4% increase revised to 0.3%. The June utility surge also inflated goods production measures that use electricity consumption as a surrogate for production volume. June's year-to-year growth rebounded to 3.9% from 2.7% in May, also due to the effects of extreme weather.

Next Release (August 16): With the economy entering a contraction, overall industrial production will enter a period of protracted decline within the next several months. Where the series is hostage to unusual weather patterns, extreme heat in July should keep the next report in positive territory, but at a lower growth rate than in June. The report for August looks like the most likely one to take series into monthly decline.

New Orders for Durable Goods -- Seasonally-adjusted new orders for durable goods in June increased by 1.4% (2.2% net of revisions) after May's revised 6.4% gain (previously 5.5%). June year-to-year growth eased slightly to 11.7% from May's 12.2% (was 10.5%). The widely followed nondefense capital goods orders, however, eased by 1.9% after May's revised 16.1% surge (was 14.5%).

Monthly volatility is high for this series. Durable goods orders used to be one of the better leading indicators of broad economic activity, when smoothed using a three-month moving average. After the semi-conductor industry stopped reporting new orders, the series' predictive ability fell apart. A benchmark revision is due for release on August 19th.

Trade Balance -- The seasonally-adjusted May trade deficit in goods and services narrowed to $55.3 billion from April's $56.9 billion (was $57.0 billion). While there will be months when the trade deficit will narrow, May should not have been one of them. As has surfaced in a number of other reports during the last month, unusual seasonal factors came into play. Seasonally adjusted on a consistent basis with last year, the May deficit would have come in at $58.5 billion, just shy of last November's record $59.0 billion.

Separately, part of the monthly improvement in the deficit was due to reported lower oil imports, both in terms of physical volume and in pricing. Those trends will not continue for long. Also, the recent trend of an increasing surplus in services trade is highly suspect, since 95% of the series is a guesstimate.

Despite the apparent games playing with seasonal factors, the general pattern of the trade deficit widening on a regular basis should continue, with new record deficits in the months ahead.

Next Release (August 12): The June trade deficit should widen sharply, beyond market expectations, and there is a fair chance of a larger May deficit resulting from revisions. If those numbers come to pass, the revision to second-quarter GDP growth should be to the downside.

Consumer Confidence -- July 2005 confidence faltered in both monthly and annual growth. Month-to-month, the Conference Board's consumer confidence fell by 2.8%, while the University of Michigan's consumer sentiment was up 0.5%. Year-to-year change turned negative for both measures in the month with confidence and sentiment down 2.4% and 0.2% respectively.

On a three-month moving average basis, annual change in confidence slowed from 6.1% in June to 3.6% in July, while the annual decline in sentiment narrowed from a contraction of 3.4% in June to a 1.1% decline July. As lagging, not leading, indicators, these numbers continue to confirm the economy was slowing throughout fourth-quarter 2004, then stagnating and slowing again into second-quarter 2005.

Short-Term Credit Measures -- Consumer Credit, Commercial and Industrial Loans and Commercial Paper Outstanding showed respective annual growth rates of 4.4% (June), 11.5% (June) and 9.2% (four weeks ended August 3). These series and current growth patterns all are reviewed in this month's "Reporting Focus."

Producer Price Index (PPI) -- The seasonally-adjusted June finished goods PPI was unchanged (a decline of 0.1% unadjusted) for the month, after May's 0.6% drop. June's annual inflation rate notched up to 3.6% from May's 3.5%, despite an understatement of energy costs similar to that which depressed CPI reporting.

Next Release (August 15): Despite a large component of random volatility in monthly price variations, PPI inflation reporting over the next several months should shock the markets beyond existing expectations. Consensus forecasts for July's monthly gain appear to be around 0.5%.

Purchasing Managers Survey (Non-Manufacturing) -- Published by the Institute for Supply Management (ISM), there is nothing unusually wrong with this survey of the service industry, except it does not have much meaning. Unlike its older counterpart, the manufacturing survey, if service companies such as law firms, hospitals or fast-food restaurants have "increased orders," that does not necessarily mean that economic activity is increasing.

Such considered, the overall July index fell to 60.5 from 62.2 in June, running counter to seasonally-adjusted strength in the manufacturing series. The index is a diffusion index, where a reading above 50.0 indicates a growing service economy, in theory. Both the employment and prices paid components, however, have some meaning.

The July employment component fell to 56.2 from 57.4 in June, suggesting slowing employment growth in the service sector.

The prices paid component diffusion index is a general indicator of inflationary pressures. The July index exploded, rising 17.6% from June's 59.8 to 70.3. This was the second consecutive increase in the level of the prices paid index, which has retaken a level consistent with significant inflation. On a three-month moving average basis, though, the annual change in July narrowed to a decline of 13.5% versus the 16.4% drop in June.


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 -- Rising for a second month, the July new orders index was 60.6, up from 57.2 in June. The measure, though, still has breached its fail-safe point, generating an SGS early warning indicator of pending recession.

The Commerce Department provided suspect seasonal factors for this series, and adjusted monthly numbers often can be misleading in the reporting of month-to-month change. This problem is overcome by using year-to-year change on a three-month moving average basis. On that basis, July's index was down 10.6% year-to-year versus a 15.1% contraction in June. The index gradually has notched lower from its peak annual growth of 36.6% 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 above 50.0 indicates rising new orders. The overall July ISM rose to 56.6 from June's 53.8. An index level of 50.0 divides a growing versus contracting manufacturing sector. Also of note, the July employment component increased, moving from an outright contraction level of 49.9 in June to 53.2, in positive territory.

Help Wanted Advertising Index (HWA) -- The June index notched higher from 37 in May to 38, two points off the low of the 2001 recession and current cycle. This series is best viewed on a year-to-year basis with a three-month moving average.

For June, that annual change in the three-month moving average held at a decline of 0.9% for a second month. HWA is one of those series that never recovered from the 2001 recession, having been at its cyclical nadir and multi-decade low of 36 as recently as November 2004. Accordingly, current movement still is bottom bouncing but worthy of close attention.

Published by the Conference Board, the HWA is a reliable leading indicator of employment activity.

Of note, the Conference Board just introduced a new series that measures help-wanted advertising on the Internet. Without any historical series behind it, however, the new information has limited value at present. Still, the measure has the potential of becoming a valuable, leading economic indicator.

Housing Starts -- Seasonally-adjusted June housing starts were unchanged versus May, following May's 1.1% decline (revised from a 0.2% gain). On a three-month moving average basis, June year-to-year change turned positive after May's 1.4% annual decline. Housing starts remains a series at the brink of generating a recession warning signal.

Money Supply -- Annual money supply growth still is generating a solid recession signal. Before inflation adjustment M1, M2 and M3, monthly changes for July (four weeks) versus June were down 1.3%, up 0.1% and up 0.2%, respectively. Year-to-year rates of change in seasonally-adjusted July (four weeks) and June M1, M2 and M3 were 1.4%, 3.7% and 5.0%, and 2.1%, 3.6% and 4.8%.

Adjusted for CPI inflation, July's M1, M2 and M3 annual year-to-year rates of change were down 1.5%, up 0.7% and up 1.9%, respectively, versus down 0.4%, up 1.0% and up 2.2% in June. On a three-month moving average basis, these annual rates of change were down 0.7%, up 0.7% and up 1.8%, levels that are well underwater using the old-style CPI.


Inflation Indicators

Purchasing Managers Survey (Manufacturing) - Prices Paid -- The July prices paid diffusion index continued declining, falling to an outright contraction level of 48.5 from June's 50.5. On a three-month moving average basis, July's year-to-year change slipped to a 35.7% decline versus June's 29.6% drop.

Published by the Institute for Supply Management (ISM), the prices paid component of the purchasing managers survey is a reliable leading indicator of inflation activity. The measure is a diffusion index, where a reading above 50.0 indicates rising inflation.

Oil Prices -- West Texas Intermediate Spot (St. Louis Fed) jumped to still another monthly record high average in July, at $58.70 per barrel. That was up 4.4% from June and a highly inflationary 44.3% above July of 2004. Spot prices have continued rising into August. Despite any near-term sell-offs and ongoing price volatility, high oil prices are a major contributing factor to the inflation side of 2005's inflationary recession.

Oil price changes permeate costs throughout the economy, ranging from transportation and energy costs, to material costs in the plastics, pharmaceutical, fertilizer, chemical industries, etc. Where effects of continued oil price volatility will affect CPI reporting, downside oil price movements tend to be picked up more quickly and fully than are upside movements. Even as currently understated, CPI inflation should be much stronger than commonly predicted for the next six-to-nine months, partially as a result of continued high oil prices.

U.S. Dollar -- The Shadow Government Statistics' Financial-Weighted U.S. Dollar Index is based on dollar exchange rates weighted for respective global currency trading volumes. July's monthly dollar average gained 1.9% from June, following June's 2.4% increase over May. Year-to-year change moved from a 2.1% contraction in June to a 0.9% gain in July.

Meaningfully softer than this month's financial-weighted index, July's monthly average of the Federal Reserve's Major Currency Trade-Weighted U.S. Dollar Index rose 1.0% after June's 1.9% increase. July's annual change eased to a contraction of 0.7%, following June's 2.9% decline.

The current relative surge in the financial-weighted versus the trade-weighted index often is seen before a major break to the downside for the U.S. currency.

China's incremental move in revaluing its currency against the dollar or an unpublished/imaginary basket of currencies is not good news for the U.S. dollar. Pressures will mount for further action, with an eventual sinking of the greenback and a broad abandonment of foreign central bank funding of runaway U.S. deficits. The near-term dollar rally should be close to having run its course, with underlying fundamentals remaining extraordinarily negative for the U.S. currency. With serious shocks looming in U.S. economic and fiscal data, heavy selling pressure against the U.S. currency could unfold at any time, with little warning. New record lows for the dollar remain likely in the months ahead, despite current strength and any overt or covert supportive intervention by any central bank(s).

Generally, the weaker the dollar, the greater will be the ultimate inflation pressure and the eventual liquidity squeeze in the U.S. capital markets.


AUGUST'S "REPORTING FOCUS" -- SHORT-TERM CREDIT MEASURES: CONSUMER
CREDIT, COMMERCIAL PAPER AND COMMERCIAL AND INDUSTRIAL LOANS
Added to this month's reporting and analysis are several measures of short-term credit for consumers and businesses: Consumer Credit, Commercial and Industrial (C&I) Loans and Commercial Paper Outstanding. Each series is of reasonably good quality, is published by the Board of Governors of the Federal Reserve System and tends to move in response to business conditions. Accordingly, these series are viewed as lagging indicators to economic activity. At present they tell a mixed story of business activity, suggesting that the 2001 recession lingered into 2004 or beyond, and that the economy may have started turning down again.

Consumer credit has tracked recessions closely over time, although downturns in consumer borrowing during 1985/6 and 1996/7 mirrored economic slowdowns noted in the business community but not in official GDP reporting. The series includes credit card debt; it does not include longer-term debt such as mortgages.

The last peak in year-to-year growth was at 11.7% in April 2001, right after the official onset of the recent recession, though some months after the economy had slowed significantly. Following the pattern of the down economy, year-to-year growth in consumer credit fell to below 5% as of February 2003 and has stayed there since, never recovering. Growth just reported for June 2005 was up 4.4% year-to-year.

Commercial and industrial loans and commercial paper outstanding need to be viewed jointly as they both reflect short-term borrowing by businesses. Annual growth in C&I loans peaked around 11.4% in July 2001 and fell sharply into negative by December of that year. No recovery was seen until the Fed began tightening in July 2004. Growth since had returned to the 11.5% level as of June. Annual growth in commercial paper outstanding, peaked around 36% in September 2000, sank sharply into negative territory and began recovering around May 2004. Growth plunged anew, however, after peaking in May 2005 at about 29%. Year-to-year growth as of the four weeks ended August 3 had fallen to 9.2%. The data on commercial paper is more current than the C&I numbers by over a month.

Certainly the environment of unusually low interest rates has distorted borrowing patterns for these series, as both consumers and business have moved to lock in longer-term funds at historically low interest rates. Nonetheless, the pressures of the business cycle still push short-term credit activity, and there are, again, hints in these data of a more prolonged 2001 recession than formally is recognized, and of broad economic activity perhaps taking something of a hit during second-quarter 2005.

As interest rates reach more normal levels, these credit series may give us additional reliable indications of what is happening in underlying business activity.


UPCOMING "REPORTING FOCUS" FOR SEPTEMBER --
INCOME VARIANCE AS A PREDICTOR OF LONG-TERM TRENDS
For the leading economic indicators analyzed monthly in SGS, lead times to broad economic activity range between three and nine months. There is one indicator, however, that signals broad trends in liquidity and economic activity three to eight years in advance: income variance. That indicator will be added to the SGS next month, but since the number gets updated only once a year, commentary will tend to be updated similarly. The record high level of U.S. income variance in 2003 was not a positive indicator for the domestic economy during the last half of this decade; 2004 data will be available at the end of August.


Update: SGS Alternate Consumer Price Index

Response to the Shadow Government Statistics' early-June announcement of an alternate, monthly consumer price index, to be published starting fourth-quarter 2005, has been overwhelming. It has been both highly positive and supportive.

The SGS index numbers will be set -- not subject to revision -- and usable in calculations in the same manner as the official CPI. A history going back to 1990 will be reconstructed, with a bridge to pre-1990 CPI reporting.

A full methodology will be published, in advance, and results will be replicable. The SGS index calculations will be fully transparent and based on publicly available data, not on massaged surveying by the Bureau of Labor Statistics, or over-modeled and over-theorized price levels.

Publication of the methodology and release of summary inflation results for recent years presently are targeted for mid-October. Early indications are that the annual inflation in the new series will tend to run at least three-percent higher than the government's current official inflation reporting. The full series and monthly historical data should be released by late-November. As always, any comments or suggestions are welcome.

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September's Shadow Government Statistics is scheduled for release on Wednesday, September 7, 2005. The monthly newsletter regularly is posted the Wednesday following the Friday release of the employment statistics. The posting of the September SGS on the Web site, as well as any interim alerts, will be advised immediately by e-mail.

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