In past articles we have talked about inflation somewhat. Now we come to the important message in all this. We need to now turn to how "inflation" relates to the coming U.S. Housing Bust and the future for Gold, a simple motivation. Federal Reserve policy is established based on a faulty assumption that the CPI is an adequate measure of price stability. That measure is likely to rise causing the Federal Reserve to respond by tightening monetary policy and bursting an already shaky Housing Bubble..

Summarizing our analytical plan probably would be helpful. In this article we will generally pursue the first items of the following list. We will then conclude this initial discussion in the next issue of THE VALUE VIEW GOLD REPORT and with a follow up article here at www.kitco.com.

1. The CPI is a faulty measure of price stability.

2. The weak CPI has been used as justification for low interest rates.

3. Monetary stimulation has caused a Housing Bubble that is already showing

signs of weakness.

4. The CPI is likely to give much higher readings.

5. Higher CPI readings will force the Federal Reserve to raise interest rates.

6. Higher interest rates will pop the Greenspan Housing Bubble.

7. Housing prices in the U.S. will collapse by ??%, or more.

8. U.S. economy will enter second economic dip, approaching depression conditions.

9. Foreign investors will dump U.S. securities, particularly those related to housing

like the Fannie Mae and Freddie Mac.

10. The U.S. dollar will undergo forced devaluation by global financial markets.

11. Your Gold holdings will become worth a lot more as Gold takes further

steps toward US$1,255.

An important message to start with is that the Consumer Price Index(CPI) does not equal inflation. Inflation is an in increase in the general level of prices within an economy. The CPI is an artificial measure, created by the government's statisticians, of the prices of a basket of goods. This measure may or may not bear a close resemblance to the general price level in the society or the prices of goods purchased by many consumers.

The problems with the CPI include all those that skeptics of government statistics might conclude. However, the CPI has been especially vulnerable to philosophical manipulation during the past decade as politically motivated groups sought to change it to match their view of the world. But, why should all that surprise many of us?

Changes to the CPI have had several purposes and goals. One of the goals of the construction of the CPI was to minimize the annual increases in Social Security payments. If the government could create a measure of inflation that presents a low picture of inflation, then the burden of higher Social Security payments would be reduced.

Other consequences exist from the use of the CPI as a proxy for inflation. The Federal Reserve in part uses this faulty measure to justify whatever monetary policy spilled on the Chairman's napkin that morning at breakfast. The CPI as an adequate price measure for guiding monetary policy can be added to the list of delusions which already includes the "productivity miracle" and the "new economy."

An understanding of the implications of using this faulty measure of inflation is necessary for investors. A strong connection exists between the CPI and U.S. monetary policy. U.S. monetary policy lacks an intellectual base but rather rests on some form of intentions partially justified by what the CPI is doing. The CPI is part of the many problems that insure that economic instability will be the only consequence of U.S. monetary policy.

The danger of using the CPI along with other fantasies such as the "productivity miracle" and the "new economy" to formulate monetary policy is now fairly obvious to everyone except the Federal Reserve and economists on Wall and Bay Streets. Economic collapse in many sectors of the U.S. and Canadian economies has been a direct consequence of U.S. monetary policy. That much of the telecommunications and technology sectors have been laid waste is a consequence of using faulty measures and fantasies to set monetary policy.

That the failure to include a consideration of financial bubbles in the setting of monetary policy was and is a mistake now certainly clear from the U.S. economy's performance. Any argument to the contrary simply ignores the facts. Unfortunately the two new appointees to the Federal Reserve are more of the same. We can expect more damage to the U.S. economy from Federal Reserve policy and Gold investors will be the beneficiaries of that action.

The CPI fails to adequately include financial asset "inflation" or housing "inflation" created by bubbleconomics. IF the CPI is to be THE measure of inflation then it should include adequately financial asset prices and housing prices. IF the CPI is not to include these considerations then it should have no role in the determination of monetary policy.

The current approach to setting monetary policy directly contributed to the Greenspan Stock Market Bubble. Collapse of that bubble was inevitable. Economic problems were also a natural consequence of those events. The Greenspan Housing/Mortgage Bubble will have the same consequences, and further benefit those invested outside the U.S. dollar and in Gold.

In the remainder of this discussion we will look at the present situation regarding the CPI. Then move onto the implications for monetary policy. Next the negative consequences for housing will be considered. The prospects for housing prices and the U.S. dollar will be next in line. Readers are strongly recommended to review our previous article which can be found at: http://www.kitco.com/ind/Schmidt/june102002.html

In the first graph is plotted the year-to-year rate of change for the Naive CPI and the Median CPI. The Naive CPI is the number released each month by the government and purported to be the measure of "inflation." That measure is the lighter and more volatile line in the graph. As we have written previously, the Median CPI produced by the Federal Reserve Bank of Cleveland is a better measure of the central tendency for inflation than the Naive CPI. This measure is the dark line in the first graph.

The first of those measures is what we refer to as the "Naive CPI," and again is the thin line in the graph. We give it that name cause anyone that truly believes a government number is naive. The second measure is a much better indication of the central tendency of inflation. At the Federal Reserve Bank of Cleveland their talented researchers calculate each month a "Median CPI," the bold line.

The Median CPI, as can be seen in the graph, is running just off the highest level since the early 1990's. On a year-to-year basis this measure indicates that inflation is about 3.4%. The Naive CPI, used by the Federal Reserve for decision making, is up 1.1% on a year-to-year basis. The better measure of inflation, the Median CPI, is more than three times the rate indicated by the government statistic used by the Federal Reserve to set monetary policy.

This Median CPI has another use as previously reported. It can be used to create buy and sell signals on "inflation," the Naive CPI. This is done by using the simple difference between the two measures. When the difference between the Median CPI and the Naive CPI gets too large the tendency is for Naive CPI to change directions. We have plotted those signals in the graph with triangles.

In the second graph we are able to take a close up look at the inflation reporting. In 1998 you will note that the Naive CPI was running just over 1% on an annual basis. The Median CPI was running more like a 3% annual rate. That low rate of "inflation" was used as justification for the aggressive easing of U.S. interest rates by the Federal Reserve. However, the Median CPI indicates that reliance on the Naive CPI was an error.

That monetary ease had two results. First, the excessive liquidity provided the U.S. economy based on this false picture of "inflation" flowed into the stock market creating the Greenspan Stock Market Bubble. Second, the excessive liquidity caused the Naive CPI to rise to nearly 4% on an annual basis. While that does not seem high, note that it is about three times the starting level.

As the CPI rose the Federal Reserve began to reverse policy. Their action was not taken because of the financial asset bubble developing in the stock market. The rationale for raising rates was the rising rate of increase in the Naive CPI.

After the stock market bubble popped the U.S. economy entered into an economic slide. The rate of increase in the Naive CPI fell off. The Federal Reserve responded, slicing interest rates due to the low level of naive "inflation" and due to their fear of economic collapse brought on by their stock market bubble popping.

At the present the Naive CPI is up 1.1% from a year ago. Inflation is again under control is the claim of many. The Median CPI, however, continues to run at a much higher rate as shown in the graph. The difference between these measures continues to give buy signals on the Naive CPI. Given these signals, we can expect the rate of increase in the Naive CPI, what is commonly referred to as inflation, to increase.

The easing of interest rates during the past year was accomplished by a massive injection of liquidity into the U.S. financial system. That excessive liquidity has been flowing into the housing sector of the economy. A massive Housing Price Bubble developed. Indications are that the Housing Bubble is already losing steam, but we will cover that subject in the next article.

Federal Reserve policy is in part focused on the Naive CPI, and the rate of change in that measure. That rate of change is mistakenly referred to as "inflation." When that measure rises the Federal Reserve feels the need to respond by raising interest rates. The differential between the Median CPI and the Naive CPI is already indicating that "inflation" will move higher.

In the next chart is the historical record of the year-to-year increase in the Naive CPI, "inflation." This chart includes a number of important points, but let us focus on the easiest first. The rate of "inflation" has reached this level twice before. Each time the rate of increase in the Naive CPI, "inflation," rose in the subsequent time period. With the buy signal on "inflation" in place, a reasonable expectation is that "inflation" is about to rise.

The Federal Reserve typically responds to a rising rate of "inflation" by tightening monetary policy. Interest rates will go up, and due to a collapsing dollar up by far more than any expect. Rising interest rates will rip the gut out of the already weakening trend for housing prices. A major collapse of the Housing Bubble can be expected as a result of this development. The final blow will be administered to the U.S. stock market, sending it to lows that will even shock big Bears. Note that the coming election may dampen the Federal Reserve's willingness to raise rates, but that will simply cause the pressures to build to a greater degree producing a far larger and longer penalty phase.

The U.S. economy will be sent into another recessionary dip. With the stock market already decimated and housing prices collapsing, the financial shocks to the U.S. economy will be tremendous. Foreign investors will withdraw billions from U.S. financial markets. Financial institutions such as Freddie Mac and Fannie Mae will likely experience massive difficulties. The U.S. dollar will move toward its intrinsic value, the cost of the paper on which it is printed.

One final chart for those somewhat skeptical before we close. In the last graph is plotted both the annual rate of change and the six-month rate of change annualized. The process of moving to higher "inflation" has already started. The six-month rate of change has been moving up strongly, suggesting that "inflation" is headed higher.

In the next article we will look closer at the Housing Bubble and the implications of its implosion on housing prices. Our first estimate is that on average a decline of ??% can be expected. The period of declining housing prices should last for several years.

A collapse of the Greenspan Housing Bubble will result in a traumatic experience for the U.S. economy. Confidence in the management of the U.S. economy will collapse. That the U.S. economy is headed down rather than up will crack the faith in the U.S. dollar and U.S. financial assets. The foundation for the coming Super Cycle in Gold that will carry to over US$1,250 is about to be put in place.

FROM A ONCE STRONG HOUSING MARKET: HONG KONG

From Business Week, 29 July 2002: "Property prices have fallen the most, plunging 60% and leaving as many as 100,000 homeowners owing the banks more than their apartments are worth. . . . Just ask Louie Lau. Back in 1997, he paid $307,000 for a 500-square foot flat in Sheung Shui near the Chinese border. Today his flat is worth 25% less than the $200,000 he still owes the bank."

FROM ANOTHER STRONG HOUSING MARKET: FLORIDA

From Sun-Sentinel, 26 July 2002: "Despite continuing low mortgage rates, sales of existing single-family homes in Florida stood at 14,407 units in June, only 28 units higher than same-month sales in 2001."

MEDIA CONSPIRACY REPORT:

The conspiracy of the popular media to not report on Gold continues. We have decided to periodically report on the failure of the popular media to report on Gold or Silver. Quite frankly the journalistic community is failing to live up to that which we would consider good "journalistic" standards. This weekend we read the latest issue of MONEY, a popular magazine for mutual fund junkies and other misguided individuals. Save your money, and rather than buy this magazine buy a candy bar.

We award the latest issue of MONEY magazine a GIANT "F." The magazine carried a report on 100 mutual funds to buy for the future. Yes, you are right. Not one of them, unless we missed it, invested in Gold. While something somewhere in the magazine might have said something about Gold, we could not find it. This "magazine" has, in our opinion, some serious "journalistic" quality issues that need to be addressed. Gold investors will gain little from subscribing to this magazine.

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Ned W. Schmidt,CFA,CEBS publishes THE VALUE VIEW GOLD REPORT, a monthly review of the developing Gold Super Cycle. His major report, “$1,245 GOLD”, 150+ pages with 70 charts and graphs, is essential reading for investors wanting to understand the coming Gold Super Cycle. As a special offer "$1,245 GOLD" is available for $45.

This report can be ordered by contacting Ned at nwschmidt@earthlink.net
or by clicking on this button