In 1980, Fed Chairman, Paul Volker, had to raise interest rates to 20% to fight 15% inflation. Today with inflation at 9% using the same metrics, Bernanke has pledged to keep rates at 0%. Does anyone see a problem looming here?

So what does this mean for investors? Well if the true inflation rate is 9%,  then the real interest rate on a 5 year treasury bill yielding 2.2% is negative 6.8%. That is, a 5 year t-bill is loosing 6.8% of purchasing power every year. (That would explain why the only buyers of government debt right now are the Fed, and to a lesser extent, foreign central banks.) It is clear that interest rates will need to rise moving forward to keep inflation from getting out of hand. That means our Federal interest payments will increase, mortgage rates will increase further depressing the housing market and sending banks back into insolvency, and credit will shrink, depressing the economy. Since the Federal Reserve is looking at the phony CPI inflation rate, they will continue to be behind the curve keeping real interest rates negative as far as the eye can see. Negative real interest rates are one of the main reasons gold, silver and other commodities continue to rise.

The other reason we can count on the Fed to keep rates lower than they should be, is that they focus on the “core” inflation rate, which excludes the price of food and energy. Their justification is that food and energy prices are volatile and not indicative of “underlying inflationary trends.” This is another line of BS. It may be true for month to month numbers, but over the course of a year or more those price rises are simply due to constant money printing. The Fed can’t claim bad weather for the past decade. Food and energy prices could be normalized using a moving average number if volatility was the real concern. Everyone needs food, and rising energy costs affect the cost of everything. To dismiss them is disingenuous at best.

One final reason why the CPI by itself is a bad metric to guide Fed policy and investment decisions is that it is backward looking. There is a lag time between when the Fed prints money and when that inflation shows up in rising prices. Just because the CPI has been fairly tame so far, doesn’t mean it will continue to be. In fact, from just November of 2010 to February of 2011, the annualized CPI number rose from 1.1% to 2.11%.

2. Unemployment Rate

The official report we hear in the media is that unemployment is rate is bumping along around 9%. This reported rate, labeled U-3, includes unemployed people who are considered part of the civilian labor force but does not account for people working part-time who would prefer full-time work and discouraged workers who have given up looking because they feel they have no prospects.

The broadest (and rarely reported) official unemployment number by the government is the U-6 number which includes those part-time workers and discouraged workers who have looked for a job in the past 12 months. The shadow government stats number on the chart below, includes long-term discouraged workers who as John Williams says, “were defined out of official existence in 1994.”

So which is the right number? Probably none on their own, but instead it’s important to look at all of these metrics together along with other indicators. The important takeaways are these:

1. The 9% number you hear on the news is only one piece of the puzzle. The actual percentage of workers who are negatively affected by the job market is actually much larger. This means more people who have to cut back on their spending, more people dipping into their savings, more people who’s skills are atrophying, and more people receiving funds from the government. None of these trends are good for the economy.

.2 It is possible for the unemployment rate to go down, as it has been for the past few months, without increasing jobs. This is because as people give up on looking for a job, they are no longer part of the official labor force so the denominator in the equation shrinks.

3. Gross Domestic Product (GDP)

Gross Domestic Product is the most commonly used measure of economic production in the overall economy in a given time period. The GDP is used to gauge the growth of the economy and is seen by many as an indicator of the country’s standard of living. The GDP is useful as a general measure of the size of the economy and also as a reference for other financial indicators such as the national debt. For example, a $14 trillion national debt doesn’t mean much on its own until you compare it to the overall size of the economy, a.k.a. debt to GDP ratio. (And when you do that for the US, you’ll find a debt to GDP ratio nearing 100% which is downright scary.)

The problem many people have is an over-reliance on the overall GDP number as an economic indicator. The GDP can be calculated in a few ways, but the most common is by tallying up the expenditures on personal Consumption, private Investment, Government spending (federal, state and local), and net exports. It can be expressed be the formula:

GDP = C + Inv + G + (eX – iM)

As you may have deduced from the above formula, not all GDP is created equal.

A high level of Consumption simply means that consumers are living well that period. I would consider this a neutral component, although rising consumption could indicate an increase in earnings, which is good, or a decrease in savings and higher borrowing which just means less consumption in the future. With high personal debt levels, low savings and high unemployment, the future doesn’t look strong for the spending component of GDP.

A high Investment component means that companies are investing in capital equipment and R&D to increase productivity which helps grow the GDP in the future. This is a very positive and sustainable means of GDP growth.

A high Government component as a percentage of GDP is generally a drag on the economy. Every dollar the government adds to the GDP, must first be taken from companies and consumers in the form of taxes and inflation, or borrowed. Borrowing from other countries simply steals from the future and at a certain level (which we are fast approaching) even hurts present GDP. Some basic levels of government spending can be good for sustained GDP growth by maintaining the rule of law, defending the country and providing some crucial infrastructure investment. Unfortunately, we are waaayyyy beyond that level and addition government spending only detracts from sustainable economic growth.

A high net exports component means our country is increasing its wealth by producing goods and selling them to other countries. Unfortunately, our net exports have been negative for decades. We were able to do this because we had a high level of wealth built up in this country that we could use to buy foreign goods, and because we could print the reserve currency of the world and trade dollars for goods.

The bad news is, the only component of our GDP that seems to be growing right now is the Government expenditures. And in fact, government expenditures are underrepresented by the GDP numbers because transfer payments such as Social Security, Medicare, bank bailouts and homebuyer tax credits are counted in the consumer spending category when the recipients of these transfer payments buy goods. It should also be noted that government expenditures are growing through borrowing from other countries and printing by the Fed. This is not good GDP growth.

When economists look at GDP growth, they adjust the numbers for inflation to get a better feel for the real growth of wealth. As discussed above, the inflation numbers as calculated by the CPI are dubious at best. Below is a chart of GDP annual percentage change adjusted for inflation using the government numbers and Shadowstats numbers.

If you believe the government numbers, we came out of the recession in 2009. If you instead use the Shadowstats numbers, you would conclude that the recession is ongoing.

4. Government Debt and Deficit Accounting

Most people who are paying attention can tell you that the national debt is around $14 trillion and our deficit this year is around $1.6 trillion. That sounds pretty bad.

But in the world of government numbers, the numbers you hear are only part of the story. It turns out the reported budget deficit (or surplus) is only part of the amount that gets added to the national debt each year. It doesn’t include off budget items like emergency war appropriations and earmarks. The chart below compares the reported deficit numbers with the actual increase in the debt.

But there’s more. The government reports its debt and deficits on a cash accounting basis. That is, the yearly deficit is simply the amount of money it spends minus the amount it takes in for a given year. It does not include the future liabilities the government has promised to pay for entitlements or the federal guarantee of Fannie Mae and Freddie Mac. If a corporation tried to run its books this way it would get dragged over the coals. Public companies report their books based on generally accepted accounting principles (GAAP) which account for the present value of future liabilities and assets. Though not widely reported, the US Treasury does offer GAAP based accounting statements for each year which are shown below for 2010.

Federal Deficit 2010 ($Trillions)

Formal Cash Based Accounting: $1.294

GAAP (excluding SS and Medicare): $2.080

GAAP (including entitlements): $5.300 (1)

(1) This is John Williams estimate for 2010 and is similar to the official 2009 number. The official reported 2010 number of -$7T includes a one time $12.3T write down of the net present value of medicare liabilities based on favorable assumptions of the new healthcare bill.

Federal Debt 2010 ($Trillions)

Cash Based Gross Federal Debt: $13.6

GAAP Total Federal Obligations: $76.3 (2)

(2) Again, this doesn’t include the $12.3T write down. The official government number is $64T. I’ve also seen numbers over $100T for the total federal obligations from other sources.

Countries get themselves into big trouble when their debt to GDP ratio reaches 90%. Bond yields have skyrocketed in countries like Italy, Greece, Ireland and Portugal with high debt to GDP ratios. The only reason our rates haven’t risen as well is because we can print the reserve currency of the world.

Our debt to GDP is quickly closing in on 100%. But if you look at our total Federal obligations, our real debt to GDP ratio is over 500% of GDP.

Summary

If we take the government’s numbers at face value it’s easy to see why some economists and market analysts are sanguine about the economy. It looks like inflation is not too bad, unemployment is high but gradually improving, low interest rates should continue to boost the stock market, the GDP is expected to rise 4% or so this year, and the debt may be high, but interest payments are low due to low rates.

But if you look behind the official numbers and see how they are misrepresented, manipulated and misused, the picture is rather grim. So how do these numbers tie together and what does it all mean?

If we understand the inflation is around 10% and rising, and that real unemployment rates are somewhere around 20%, we realize that consumers will have less discretionary purchasing power. That means the “C” part or the GDP equation is headed down in real terms.

If we realize that manufacturers are at roughly 75% capacity utilization (one of the reasons Keynesians think there can be no inflation) and that companies’ margins are being squeezed by higher costs, more regulation and poorer customers, then we can bet that the “I” part of GDP won’t be increasing any time soon despite low interest rates and government stimulus for investment.

Net exports continue to subtract about 5% from GDP each year.

That leaves government to continue to fill in the gap if we want to grow GDP. But government can only spend what it taxes, borrows or prints. Higher taxes would put downward pressure on an already fragile recovery and wouldn’t bring in much more revenue. Borrowing is becoming harder as our lenders realize that real interest rates are negative and that our debt is almost 100% of a GDP bubble. That leaves printing as the only means of growing government spending and thus nominal GDP.

If the Fed continues to print by buying up Treasuries, the GDP may rise nominally, by it would fall in inflation adjusted terms and could even precipitate a collapse of the dollar. If they stop printing, the government would be forced to drastically cut back on its spending which would crash the economy. Either way the economic future doesn’t look so pretty without the rose colored government numbers to hide the ugly truth.