In recent months, investors have been unjustly chastised for their lack of consistency. In truth, they have an unblemished record of drawing the wrong conclusions. Last week’s second-quarter report on US gross domestic product provides the freshest evidence of market cluelessness.

In its report, the US Commerce Department stunned economy watchers by showing a 3.3 percent annualized increase in second-quarter GDP. The robust growth apparently wrong-footed those expecting further recessionary signals, lent further strength to the current dollar rally, and encouraged previously cautious investors to take another look at U.S. stocks. The strong number also bolstered claims by the Bush administration and the McCain campaign that a recession is primarily a psychological phenomenon. These conclusions would be at least quasi-logical if they were not based on a complete misreading of the report.

Without raising an eyebrow on Wall Street or in the press, the GDP deflator, used in the report to downwardly adjust GDP to account for inflation, was shown at just 1.2 percent annualized – the lowest deflator in ten years. In other words, to arrive at 3.3 percent growth, the government assumed that inflation is running at a 10-year low. In contrast, the latest reading on consumer prices in the second quarter shows year-on-year inflation running at a 5.6 percent rate, a 17-year high.

In fact, for the second quarter, the same time period measured by the GDP deflator, prices actually rose at an even faster pace of 8 percent year-on-year. How can it be that inflation is simultaneously running at a 17-year high and a 10-year low? Welcome to the Alice in Wonderland world of government statistics.

You would think that this statistical bombshell would raise the hackles of the press. Think again. Not only did the media completely miss the story last week, they have almost totally ignored our subsequent attempts to show them the light. Although none of the reporters we spoke with could explain why inflation could run at a 10-year low and a 17-year high at the same time, they did not deem the anomaly sufficiently noteworthy. Having been ignored by reporters, I then tried the opinion pages. Unfortunately the piece that we prepared on the subject was rejected this week by all the leading national newspapers.

Reporter Michael Mandel did note the head scratcher on a Businessweek blog posting last Friday. As a partial explanation he pointed out the Consumer priced index measures the prices of what we buy, and the GDP deflator measures the prices of what we make. Although this certainly sheds some light, it offers no real explanation. Excluding imports and exports, both measures are determined by the same forces, and should move in relative harmony. If anything, the costs of what we make should be outpacing the costs of what we buy. Producer prices are now rising faster than consumer prices (the latest annual reading of the Producer Price Index being 13.2 percent annualized from the second quarter), which helps explain why corporate profits have fallen drastically. In addition, from July 2007 through July 2008, the latest data available, import and export prices have risen 21.6 percent and 10.2 percent respectively. In other words, no matter what numbers you use, the 1.2 percent GDP deflator simply doesn’t add up.

I have often argued that government statics are dubious, particularly those related to inflation. But here is an example where they are not even consistent. If we simply use second-quarter CPI to adjust nominal second quarter GDP for inflation, the number would have registered a 3.5 percent annualized decline.

Such horrific GDP numbers are much more consistent with the anecdotal recession evidence that Wall Street and Washington want us to ignore, confirmed by Friday’s weak US jobs report, which included the unemployment rate spiking to 6.1 percent, a five-year high. However, with Orwellian propaganda, our government fabricates GDP growth out of thin air without the smoke and mirrors traditionally required for such an elaborate illusion. All that is required is to put out ludicrous statistics and hope no one notices. And no one did. Given that this strategy appears to be working, expect future government numbers to get even more outrageous. After all, if they can get away with this, they can likely get away with anything.

Investors relying on this data and reacting to the global economic slowdown by buying dollars and other U.S. based assets while selling gold, commodities, and foreign assets, are jumping out of the frying pan right into the fire. My guess is that it will not be much longer before they feel the heat.

Down the Rabbit Hole With US Statistics…

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