We are supposed to be in an economic recovery, so why are employment figures weak and long-term interest rates low? The answer may lie in the way government calculates our Gross Domestic Product (GDP). The GDP number we often see in newspaper headlines is the measure of all that our country produces, in real terms, after inflation is taken out. In other words, raw data on the dollars and cents of our economy is collected, and then the inflation is subtracted to produce Real GDP. Thus, if inflation estimates are lower than they should be, real GDP looks better than it actually is.

Obviously, the government has a vested interest in making inflation numbers as small as possible, and they have calculation methods to do just that. They give credit for increased performance of things like computers and communication equipment so prices are discounted. They also shift baskets and count housing as rental equivalent, rather than purchase price. We intuitively know the government “cooks the books” when we see them using a deflation rate of 1.3% to calculate Q3 GDP for 2004 at 4%. 1.3% seems like a significant under-estimate, given that prices in sectors such as housing are up 12%.

Since I suspect the government has designs on making the economy look better than it is by using low inflation numbers, I decided to create my own inflation indicator, an average of three common indexes: CPI U, PPI All Commodities, and the Housing price from OFEHO. This covers the main things we spend money on – housing, commodity-based goods like gasoline, and other consumer goods. Looking at the results in the chart below, my method tracks very closely with the government method up until 2000, confirming that it is a useful measure.

Since 2000, the divergence is noticeable between my numbers and the government’s. Not surprisingly, the government figures make the economy look better. I take this as evidence that this economy is weaker than the government numbers suggest. A weak economy is consistent with weak job growth, something we’ve been seeing. A slower economy is also consistent with longer-term interest rates staying low, as corporate borrowing is not needed for capital investment. We’ve also seen just such a trend in the slow demand for credit in Commercial and Industrial loans. So both jobs and interest rates are consistent with an economy that is much slower than the government claims.
In fact, the GDP report for Q4 2004 came in below expectations at 3.1%, indicating a slower economy.

Below I present an even simpler view of the GDP growth rate, using a constant 4% for inflation – a reasonable (though probably conservative) number, based on my observations — subtracted from the before-inflation Nominal GDP number the government reports.

The middle line is the headline GDP growth as reported by the government. The top line is the same number, but before inflation is removed. The bottom line is a straight removal of inflation at 4% in all periods. The trend looks down to me.

If real GDP is precariously close to no growth after tax stimulus and the lowest rates in 45 years, it does not bode well for the economy in the near future when these tail winds will likely vanish. The government may say that GDP is growing, but I for one am not convinced they are telling the real story.

Mr. Conrad holds a Bachelor of Engineering degree from Yale and an MBA from Harvard. He has held positions with IBM, CDC, Amdahl, and Tandem. Currently, he serves as a local board member of the National Association of Business Economics and teaches graduate courses in investing at Golden Gate University. Bud Conrad has been a futures investor for 25 years and a full-time investor for a decade. In his spare time, he produces Conrad’s Charts, published by Casey Research, featuring unique charts and analysis on the economy and investment markets.