The US economy posted a slower growth rate in the first quarter of 2.2%, disappointing expectations of 2.5%. The culprit wasn’t households or businesses, both of which made positive contributions. It was the government. In fact, the economy would have beat expectations if the government drag hadn’t sliced off 0.6 percentage points.

The Bureau of Economic Analysis tracks the US economy in four major categories; three of them have been adding to growth since the end of the recession in 2009. Personal consumption is the largest category, now accounting for 70% of GDP; it has already surpassed pre-recession levels in inflation-adjusted dollars and contributed to growth in all eleven quarters of the new expansion. Private domestic investment has yet to fully recover but is well above the lows, adding to GDP in all but one quarter of the expansion. Net exports, the third category, was slower to turn but has been more supportive of growth over the last year.

In stark contrast to the rest of the economy, government expenditures continue to contract and have now subtracted from real US GDP growth for six straight quarters, the longest such stretch since Eisenhower. The government, in other words, is still in recession.

About half the government drag comes from reduced military outlays, which are down 7% from the peak in September 2010 and might continue to edge down as overseas commitments are further curtailed. State and local government spending accounts for the other half; this part of the drag is beginning to stabilize and was almost flat in the first quarter.

The government’s contribution to economic growth can come directly from its expenditures and investment or indirectly through stimulus and other fiscal and monetary policies. In past business cycles since 1960,  the government itself was usually an early source of growth in a new expansion. On average, government spending directly added about half a percentage point to the growth rate through this point of an expansion, as opposed to an average quarter point reduction in this cycle.

The government’s indirect contribution has been far more robust, although the longer-term implications have yet to be seen. There has been record-setting deficit spending at the national level and the Fed continues to hold interest rates at historic lows, together boosting personal consumption and private investment. A new study from Fitch Ratings and Oxford Economics estimates that US fiscal and monetary policies added more than 4% to overall GDP over the past two years. Some of that impact could be reversed when all the stimulus ends, particularly the scheduled expiration of the Bush/Obama tax cuts at the end of 2012. And the Fed’s eventual return to tight monetary policy looms heavily on the distant horizon.

For now, the economy has been firing on three pistons: consumption, investment, and exports. Government, the fourth piston, has been seriously misfiring. The headline GDP numbers could therefore be understating the health of the US recovery. At this point, the private sector has plenty of steam, softer payrolls notwithstanding, and so the government itself doesn’t need to be an engine of growth. It might be enough if the government just weren’t such a drag.

Macro Insight: US Housing is Shovel-Ready

In past US economic cycles residential investment gave a big boost to the early stages of recovery. Not this time. Nearly three years into the expansion, the net contribution of the housing sector to real GDP is exactly zero. However, the data is beginning to stir and, critically, homebuilders could be starting to build.

Each month, the National Association of Homebuilders surveys its members about current housing conditions. The responses are then tallied into an index that is published jointly with Wells Fargo. A reading above 50 indicates that homebuilders report current conditions as being good or fair. The Housing Market Index has been below 50 for nearly six years, a record stretch of homebuilder pessimism.

The bleak outlook that homebuilders have reported in recent years is mirrored in the data. Housing starts have a strong correlation with sentiment of 0.7, according to the NAHB, and have been languishing at multi-decade lows. The stock of new houses has correspondingly plunged to the lowest in history. With supply so low, even a modest pick up in sales activity could translate in shortages of new houses in at least parts of the country. Homebuilders appear to see that turn in the data beginning to unfold.

According to the NAHB, homebuilder sentiment can lead major turning points in housing starts by four to six months. For instance, sentiment peaked during the boom in June 2005 and starts rolled over exactly six months later. During the bust, homebuilder sentiment had bottomed by January 2009 but bounced along the bottom for the next two years.

At long last, however, homebuilder sentiment is turning up, with the index doubling in just the last six months. There have been periodic upticks in this series ever since the bubble burst but nothing of the magnitude now seen in the data. Two of the line items within the survey are just as striking: “traffic of prospective homebuyers” and “expectations of sales in six months” have also doubled. The surge in homebuilder sentiment could be a harbinger of a similar acceleration in housing starts that begins to unfold through the rest of this year.

Economists predict the US economy will grow 2.4% in 2012, according to a recent survey by the Wall Street Journal, which is about the same as the 2.3% they were expecting six months ago just before the renewed strength in the housing data. They might need to start upgrading their forecasts. Residential investment usually marks the start of an economic cycle, on average accounting for one eighth of real GDP growth in the first ten quarters of post-war expansions. By coming late this time, residential investment could mean that the later stages of this cycle last longer and are stronger than the consensus expects.

Macro Insight: The Housing Hockey Stick Redux

During most of the last century, the Shiller Real Home Price Index was remarkably flat before surging into a dramatic hockey stick in the early 2000s. After the bubble burst, the index plunged and recently touched a new cycle low. Some experts argue that the index will revert to its long-term average and that home prices need to drop another 25%.

But investors should be aware that the Shiller Index itself is stitched together from several different sources; the data that is currently collected doesn’t really have a historical mean to revert to. Other data, meanwhile, suggests the worst of the bust is done.

To create a long-term real home price index (the long thick line in the chart) Yale economist Robert Shiller collected historical data back to the 1880s. As Shiller explains, the earliest segments in the index are based on surveys and newspaper ads, when hard data was scarce. Then in the 1950s the government began compiling a number of formal house price indexes, two of which are used in Shiller’s index. The Case-Shiller Home Price Index (which Robert Shiller co-created with Karl Case) takes over in 1987. The boom and bust in the overall index, therefore, is reflecting the swings in the short history of this last segment.

The apparent stability of the distant past might look different if a consistent data set were available. The Case-Shiller segment (the thin dark blue line) surged 85% during the boom and then plunged 34% during the bust. The preceding segment of the index uses data from the FHFA, formerly OFHEO (the orange line); it surged 50% during the boom and then plunged 23% during the bust. Another source altogether that is compiled by the US Census Bureau, the Quality-Adjusted New House Price Index (the green line), isolates the underlying new home price trends from quality improvements by explicitly adjusting for size, amenities, and location; it surged 25%, plunged 20%, and is now back to where it was.

Mean reversion, however, isn’t always a sure thing. During an earlier hockey stick in the late 1940s, the Shiller Real Home Price Index surged 60% and stayed there. Indeed, the index shows three distinct periods of sustained equilibrium: it held steady in its first few decades into the 1910s, dipped down to a lower level in the 1920s through World War II, then popped in the post-war surge to a higher level, holding steady for several decades until the hockey stick of the 2000s. Today’s home prices could settle into any one of those equilibrium levels … or perhaps a new and higher equilibrium altogether.

Macro Insight: China’s Yuan-O-Matic

The US Treasury recently reaffirmed that China is not manipulating its currency. Perhaps so. But over the past decade the yuan has moved against the dollar with an algebraic precision that nevertheless betrays a heavy hand by the central planners in its currency market.

Technically, China resumed a managed float in mid-2010 that allows the yuan to move within a narrow range around a basket of currencies. Chinese officials have indicated that the basket includes dollars, euros, yen, won, and several other international currencies.

Since mid-2010, while there have been short lulls in the strengthening and even a few modest reversals, the yuan’s revaluation (the blue line in the chart) has been remarkably steady. On average, the central planners have been increasing the yuan’s value nearly a tenth of a fen each day (or 0.000887 yuan). The regression equation in the chart (the pink band) has a near-perfect r-squared of 0.98. Unless Beijing’s policymakers shift course, the currency will strengthen to 6 yuan to the dollar by next November, just in time for the US presidential elections and stronger than currently priced into the futures market.

The yuan has been just as predictable in earlier years too, it’s just the equation that has changed. In 2009-10, China pegged the yuan firmly to the dollar, as it had in the first part of the decade, leaving a flat line. However, from 2005 until the financial crisis of 2008, China’s revaluation policy had an extra dimension. While the daily change was not constant, it steadily accelerated in clockwork fashion, picking up the pace a little bit each day. In that period, the polynomial regression yields a curve (the red band) with an r-squared of 0.99.

Just where the yuan should really be is anyone’s guess. Many economists look to purchasing power parity and believe the yuan remains deeply undervalued; others argue the opposite. Politically, many of China’s trade partners contend that an undervalued yuan gives it an unfair trade advantage; China says its trade surplus is already shrinking and some officials are hinting that the yuan has strengthened enough. Ultimately, at least for now, the value of the yuan is going to be what the central planners say it is. While China has made great strides toward the market in the last thirty years, unleashing powerful engines of growth and prosperity, when it comes to the currency market the best policy for investors remains: don’t fight the Red.

Macro Insight: Santa’s Empty Workshop

During last year’s holiday season, US retail sales returned to pre-recession levels. This year they are surging to new highs. Skeptical retail stores, however, are keeping inventories low. Maybe too low.

In earlier decades, inventory management used to be largely reactive to the ebb and flow of the economy. When the economy slowed, inventories built up and production was cut until the shelves were cleared, after which production eventually resumed. During the inflation of the 1970s, there was even an incentive to hold excess inventory: companies could book profits merely by buying extra quantities of stock to sit in their warehouses. Against that backdrop, the ratio of inventories to sales climbed ever higher.

An inventory revolution finally hit in the late 1980s. Inflation peaked and the cost of raw materials began a multi-decade decline, reversing the incentive for companies to buy excess inventory. Meanwhile, new thinking was gaining ground in Japan that recognized the hidden costs of excess inventories: storage fees, misallocation of resources, and the risk of holding outdated inventory, particularly in technology and other fast-paced industries. Instead of stockpiling, the new approach delivered supplies to the factory gates just in time for production. After just-in-time techniques went global, inventory cycles became less pronounced and the inventory-to-sales ratio plunged. The question is just how low can it go.

Today, “just in time” can take too long. With inventories so lean, the global economy is increasingly vulnerable to supply chain disruptions. In 2010, a volcano in Iceland interfered with the delivery of machinery parts to Asia. In 2011, Japan’s earthquake disrupted auto production all the way back to Europe. More recently, floods in Thailand shut down the production lines of hard-drive manufacturers and shortages loom throughout the computer industry.

Moreover, low inventories could reflect an overly pessimistic assessment of the economy’s near-term prospects. Inventory-to-shipment ratios are near cycle lows for US businesses broadly and are at all-time lows at retail stores. Despite the glum forecasts, consumers continue to spend and, to judge by the latest Gallup surveys, are planning on spending even more this season. With global supply chains being disrupted and inventory levels so low, the risk for holiday shoppers is that the shelves are empty before the stockings are full. In that event, the most popular present might turn out to be gift cards.

Macro Insight: The Looming US Housing Shortage

After 52 consecutive months of declining inventory, there were 163,000 new houses for sale on the US market in September, unchanged from the month before. With new homes sales beginning to perk up from multi-decade lows, demand could quickly outstrip supply. At least in parts of the country, the next housing crisis could be a shortage of new homes.

The stock of new homes for sale typically ebbs and flows with the broader business cycle (the first chart with the blue line). When the economy begins to slow, home sales drop off (the middle chart in brown) and the supply of houses begins to increase. The supply of new homes in months (the green line) indicates how long it would take for all the new houses on the market to clear at the current pace of sales. Historically, that ratio has averaged about 6 months.

At the height of the boom in the mid-2000s, demand vastly outstripped supply even as homebuilders added to the supply at a furious pace. When demand collapsed a few years later, homebuilders were slow to react, resulting in a huge supply overhang. As the crisis worsened, the inventory ratio eventually reached an all-time high of 12.4 months in 2009.

Today, the housing market is showing tentative signs of healing. Existing home sales have stabilized, house prices have bottomed, the homeownership rate has ticked up, and the threat of a massive shadow inventory is fading. Economic growth is firming in parts of the country that missed the worst of the bubble and new workers will need places to live. Rental markets are getting tighter and new housing construction could soon follow, perhaps reflected in the recent improvement in homebuilder sentiment.

With the supply of new homes at such low levels, even a modest pick-up in the pace of sales could have a dramatic impact. When the housing recovery gains real traction, the current supply of new homes could run out within a few months, leading to higher house prices, a boom in residential construction, and an unexpectedly powerful lift to the US economy.

Pudd’nhead Wilson had it right: “October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.” Even in Mark Twain’s day, it seems, October was a notorious month for stocks.

Market historians refer to October’s tendency to coincide with inflection points in stocks as the Mark Twain Effect. While it is too soon to know whether October 3 will prove to be the low for 2011, it would fit comfortably with past market cycles.

Since 1928, the market was down for the year in October a total of 37 times, but went up from there in all but 8. In those 37 years, stocks sold off through the lows for October an average of -14.3% and then rallied 5.4%, ranging from a high of 28.1% (1998) to a low of -9.9% (1973).

Fourth quarter recovery rallies can be powerful. Even in 2008, when the market plunged -42.2% by mid-October and the global economy was sliding into recession, stocks posted a respectable gain of 6.4% through the end of the year. Altogether, a third of the rallies more than wiped out the year-to-date losses and pushed stocks into positive returns for the full year. The record surge in 1998 occurred in an environment that is strikingly familiar in shape if not intensity: default fallout in Europe, central bank interventions, and pervasive but ultimately misplaced fears of a global slowdown.

While the seasonals have yet to fully play out in 2011, the persistence of the October recovery rally through all kinds of market environments is striking. This year, the S&P was down -12.6% through the October 3 low, right in line with history; by mid-month it was up 11.5%, already more than the average recovery rally but less than a third of the way to the 1998 record. There is good reason to expect more.

Although forecasts of another US recession are endemic, the hard data generally shows that the recovery is fragile but intact, from payrolls to purchasing manager surveys to retail sales. Global central banks are easing policy, Europe is edging toward a solution of its sovereign debt crisis, at least for now, and there are even early whiffs of a policy shift in China. The pieces are in place for a powerful fourth quarter rally.

Less return for more risk. That’s what the US stock market has been delivering lately. The S&P 500 has just posted its worst ten-year performance in decades. Meanwhile, volatility is its highest since the 1940s.

Since 1935, stocks have delivered an average annualized return of 11.3%, using daily data and not including dividends. During that time, however, the market’s performance has alternated between stretches of double-digit returns and periods of single-digit or even negative returns. In 1939, for instance, the 10-year price return for the S&P 500 was at a historic low of -10.0%. Returns strengthened through the 1950s, faded into the stagflation years of the 1970s, and accelerated to new highs through the tech boom of the 1990s before plunging back into negative returns more recently.

Meanwhile, market volatility has followed a different pattern. As seen in the S&P 500’s daily standard deviation and also annualized over 10-year periods, the market’s volatility was as at post-Crash highs in the 1930s, bottomed out in the early 1970s, but then began grinding higher for the next few decades before spiking after the financial crisis of 2008.

Across the grand sweep of history, the relationship between risk and return has been loose and variable. The 1950s was a golden age of high returns and low volatility. Today it is the exact reverse.

The secular rise in stock market volatility remains a mystery. Some experts attribute it to the rise of the hedge fund industry, where assets under management show a remarkable correlation. Others argue that flash trading and other computerized financial innovations are the cause. Perhaps the deeper source is technology itself, in which the dissemination of new ideas has accelerated dramatically, leading to a highly compressed life cycle for business innovation. If so, the waves of stock market performance might also become more compressed going forward.

The anemic performance of the S&P 500 over the past decade has prompted some observers to argue that the market might be in a “new normal” of low expected returns. However, few of even the most bearish forecasters would make the case for negative returns to persist for another decade. As things stand, returns can improve but the not-so-new normal of higher volatility is here to stay.

Gold has surged 500% in just ten years and recently touched a new all-time high of $1,601 an ounce. Adjusted for inflation, the price of gold was even higher back in 1980 when it reached nearly $2,000 in today’s dollars, suggesting this rally could have more to go. However, gold prices can plunge just as dramatically, as they did in the early 1980s. After all the swings, the real return from gold over the long run is about the same as a US T-Bill but with a whole lot more volatility.

For most of modern history, global currencies were fixed to the price of precious metals like gold and silver and only changed when the monetary authorities of the day adjusted their pegs. In the US, the nominal price of gold in dollar terms changed very little through the nineteenth century: gold was $19 in 1800, briefly doubled to $42 during the Civil War, and was back to $21 until the Great Depression.

By taking inflation into account, the real price of gold (the yellow line in the chart) can better reflect how the value of gold changes over time. For instance, during the Civil War, gold jumped to over $1,000 in today’s dollars. It was worth $650 through the rest of the century, dipped under $250 during the 1920s, jumped again during the Depression, and settled back down to around $200 by the end of the 1960s. When the gold standard broke down in the 1970s and central banks were free to print money, inflation accelerated into double digits by the end of the decade. Gold spiked to new highs until the Fed finally put a definitive end to the long era of easy money. With inflation headed back down, real gold prices around the world fell for the better part of the next two decades.

A new era of easy money returned in the 2000s when the tech bubble burst and central banks around the world slashed interest rates. In the US, the Fed pushed interest rates down to historically low levels and kept them there until 2004. Meanwhile, the excess liquidity created the conditions for the global credit crisis that erupted in 2008. Once again the Fed slashed rates, this time all the way to zero, and then launched two rounds of quantitative easing. After taking inflation into account, the real federal funds rate has been negative more often than not since 2001, a sustained period of monetary stimulus that exceeds even the 1970s. Gold has duly surged.

The surge in gold will eventually come to an end. If recent history is any guide, the turn will be accompanied by a clear shift in US monetary policy, as China, the ECB, and other central banks have already started to do. Whenever it comes, the plunge could be dramatic: gold would need to drop nearly 70% in dollar terms to reach its historic inflation-adjusted average. Over time, the huge swings in gold prices tend to cancel out, leaving a real return of just 1.2%. As it happens, the real return on T-Bills over the last fifty years is also 1.2%. Gold shines when currencies are losing their value, but it loses its luster in the really long run.

Macro Insight: The Fed’s Easy Money Overhang

During four years of history-making monetary policy, the Fed used just about every tool in the box. First they slashed interest rates to zero. Then they launched an unprecedented quantitative easing. After QE1 ran its course, they launched another round with QE2, which itself just ended. Barring QE3, the Fed’s massive easing policy has finally ended. But it hasn’t gone away. If it takes as long to get policy back to normal, all the stimulus that is still sloshing around the system could threaten dramatically higher inflation pressures, presenting the Fed with a fresh set of problems.

To deal with the financial crisis, the Fed had to improvise brand new approaches. In the summer of 2007, they started by cutting the federal funds rate, their customary policy tool. The Fed requires the major banks to keep a portion of their assets on reserve at the Fed against their liabilities, a balance that is monitored by the Fed each day. Banks that find themselves short can borrow from other banks that have excess reserves at the federal funds rate. If the Fed wants to lower the rate, they can add to the excess reserves and make it cheaper for banks to borrow; the banks, in turn, can then lend out to their customers at lower rates as the Fed’s easing policy radiates through the economy. By late 2008, the federal funds rate on excess reserves was already as low as it could go, so the Fed took the radical step of increasing the size of the reserve balance itself.

Quantitative easing had its roots in early 2008 when the Fed started shifting out of Treasuries (the blue shading in the chart) and into other assets that were weighing down the banking system (the red shading). By the time Lehman collapsed and the Fed formally embarked on QE1, the share of Treasuries had shrunk from its long-term average of around 90% at the start of the year to just 50%. After debasing the quality of the reserve balance, the Fed then doubled it in order to provide liquidity directly to commercial banks (such as the TARP program), to overseas central banks (through currency swaps), and eventually to the mortgage market itself (by purchasing toxic mortgage-backed securities). By the time QE1 expired in early 2010, the share of Treasuries was 34% of the reserve balance.

A few months later, QE2 began to take shape when policymakers voiced concerns about the health of the recovery and the risk of a Japan-style deflationary spiral. The Fed increased the reserves yet again, this time by aggressively expanding the purchase of US Treasuries. Where QE1 was effectively a financial rescue mission, QE2 was pure debt monetization: while it was in force, the Fed bought some 85% of all the net issuance by the federal government and ended up holding more Treasuries than the entire commercial banking system.

The Fed’s reserve balance has more than trebled to nearly $3 trillion, priming the pump for growth now and inflation later. The stimulative effects of easy monetary policy helped lift stocks, commodities, as well as the economy’s GDP. Employment and housing remain sluggish, but given the dire predictions about a plunge into another depression that surrounded the launch of quantitative easing, the Fed has done its job reasonably well. Moreover, the threat of a deflationary spiral is no longer on the radar. In fact, the greater risk now is a surge in inflation before Fed officials are able to remove the easy money overhang. The decisive upturn in core inflation could be an early harbinger of much higher price pressures to come.

Macro Insight: China’s Trade [Surplus] Deficit

After hitting record highs in 2009, China’s global trade balance is well below where it used to be and ticked up only modestly in the latest data. However, the headline number can be misleading: the trade surplus with the US continues to hit new highs while China is running massive trade deficits with the rest of the world.

Mark Twain often said that there are “lies, damned lies, and statistics.” In a highly-developed country like the United States, economic data is revised regularly and sometimes by wide margins, even with the best of intentions. In a still-developing country like China, interpreting the data can be more art than science. As Li Keqiang, the vice premier and heir-apparent to Wen Jiabao, laconically remarked to the US ambassador a few years ago, most of the statistics in China are “for reference only.”

With due caveats in mind, the world’s second largest economy reported net exports of $14.4 billion worth of goods in May 2011 on a 12-month moving average (the thick black line in the chart), about where it was a year ago. While China’s Ministry of Commerce breaks out individual countries, trade with Hong Kong is deemed to be domestic and is excluded from the export data, even though many of the goods are subsequently shipped to other countries. As an alternative, the US includes Hong Kong in its data, which currently shows that China’s trade surplus with the US is running at a record $23.7 billion (the blue line). When all the math is done, without the US, China is running a trade deficit with the rest of the world (the red line).

Although China’s policymakers argue that the trade surplus with the US is unaffected by the value of their currency, they suspended yuan revaluation when the surplus with the US contracted. Between 1995 and 2005, a period when the yuan was firmly pegged to the dollar, the overall trade balance was relatively flat, as rising imports from the rest of the world were offset by booming exports to the US. For the next few years, the export boom to the US continued unabated while non-US imports slowed and the yuan was strengthened (the shaded area in the chart). In late 2008, when the trade surplus with the US began to contract, yuan revaluation was suspended until 2010, by which time exports to the US were rising once again.

The renewed strengthening of the yuan against the dollar, however, has lagged the global surge in commodity prices. Because China is paying more for its commodity imports, the deficit with its non-US trade partners continues to grow. China has been buying US Treasuries for many years to finance its trade surplus with the US. China may need to continue doing so for some time to come to offset its trade deficit with the world ex-US and keep its overall trade balance stable.

Macro Insight: Lake Wobegon Analysts

According to Wall Street analysts, 92.6% of the companies in the S&P 500 Index are above average. Compared to the children in radio’s famed fictional town of Lake Wobegon, all of whom are above average, the stocks in the index come up short. But just barely.

Analysts use hundreds of terms to rank the stocks that they follow. Helpfully, Bloomberg has consolidated nearly 300 assorted terms into a ratings system that ranges from 1 to 5. Bloomberg assigns the highest rating of 5 to stocks that are described as overweight, must own, or any of the other 92 similar terms. A stock is rated a 4 if it is market outperform, attractive, and so forth. An average stock is given a 3. And a stock is a 2 if it is market underperform or industry underperform and a 1 if it is an outright sell or underweight.

After classifying each analyst’s rating, Bloomberg then averages them together for each security, which then makes it possible to run the numbers in a spreadsheet to tally them up. At the high end are companies with a consensus rating between the maximum 5 and 4, of which there are 242 out of 500, or 48.4% of the index (represented by the green slice in the pie chart). Another 44.2 percent are ranked between 4 and 3 (the blue slice). Another 2.0% (gray) are exactly average at 3. Of the remainder, 5.2% are ranked between 3 and 2 (pink) and just one lonely stock, or 0.2% of the index (the barely discernable red), is at the very bottom with a rating of 1.

The overall rankings show little variation over time. Currently, the median rank for all of the stocks in the S&P 500 is 3.9. Since 2008, the median has ranged between 3.7 and 4.0. Even in the wake of the 2008 financial crisis, analysts ranked most stocks now in the index above average and gave just three stocks a rating below 2.

As predictors of future returns, the consensus ratings provide little guidance. For instance, the ratings from a year ago can be regressed against the subsequent returns for the stocks in the index. Doing that math gives an r-squared of 0.004. Statistically speaking, in other words, the consensus analyst ratings for the stocks in the S&P 500 have zero explanatory power.

The opening line to Garrison Keillor’s long-running US radio show has been adopted by social psychologists to describe a cognitive bias: “The Lake Wobegon Effect” is the tendency for people to overestimate their strengths and underrate their weaknesses. While Wall Street analysts might not necessarily rate themselves as highly as they do their stocks, their perennial optimism would fit right in at Lake Wobegon.

Macro Insight: It’s the Unemployment Rate, Stupid

For incumbent US presidents looking to keep their job, what seems to really matter is whether everyone else is keeping theirs. The number of observations is admittedly small but the track record is flawless: since World War II incumbents running for a second full term won when the unemployment rate was falling and they lost when it was going up.

In the past sixty years, seven incumbent US presidents ran for a second full term. Five of them won the popular vote (the green dots in the chart) with a margin of victory that was inversely correlated to the election-year change in the unemployment rate. In 1956, Dwight D. Eisenhower successfully ran for his second term when the unemployment rate was 4.1%, down from 4.4% the year before. Improvements in the unemployment rate also marked the reelections of Richard Nixon, Ronald Reagan, Bill Clinton, and George W. Bush. The two incumbents who lost their reelection campaigns (the orange dots) faced a rising unemployment rate: Jimmy Carter in 1980 and George H.W. Bush in 1992.

The level of the unemployment rate alone gives little guidance. The unemployment rate in 1980 was 7.2%, up considerably from the year before; Jimmy Carter duly lost his bid for reelection. In 1984, the unemployment rate was actually higher at 7.5%, but was on its way down from the previous year; Ronald Reagan was reelected in a landslide. In both cases, it was the trend that mattered.

Two other incumbent presidents chose to drop out of their reelection races. However, the unemployment trends at the time hint at a tantalizing alternate history. Harry S. Truman finished FDR’s fourth term and then narrowly won a close election of his own, but sagging poll numbers led him to pull out of running for a second full term in 1952. Perhaps he should have run anyway: the unemployment rate went down that year. Similarly, Lyndon Johnson completed JFK’s term and successfully campaigned for his own first term, but in early 1968 famously declared he would no longer seek reelection. Unemployment also went down that year.

Without exception, post-war US presidents won a second full term if the unemployment rate went down during the election year, and vice versa. In 1992, Bill Clinton defeated an incumbent US president with the campaign motto, “It’s the economy, stupid.” As it turns out, at least for incumbents running for a second full term, it’s really just the unemployment rate.

Chart of the Week: Getting Paid to Borrow

As the global economic cycle advances, price pressures are picking up and some central banks have started to increase interest rates. However, in many countries around the world interest rates remain well below prevailing inflation rates. After taking inflation into account, users of credit are in effect getting paid to borrow.

During the global financial crisis, central banks around the world slashed interest rates to zero. Theoretically nominal rates can turn negative, but it would require banks to pay people to take out loans. However, real interest rates can and sometimes do turn negative.

As US economist Irving Fisher showed a century ago, the nominal interest rate can be split into two components: the rate of inflation and the real interest rate. For instance, if a borrower takes out a one-year loan at 10% when inflation is running at 2%, then the borrower is really on the hook for 8%; the rise in inflation takes care of the rest by eroding the value of the loan. If inflation is 10%, then the loan is effectively cost-free. And if inflation is even higher, lenders are, in effect, paying to lend. In real terms, many central banks are doing exactly that.

Of the 53 central banks in Bloomberg’s database, 31 have negative real interest rates (the red dots in the chart). In the US, the Fed funds rate remains at all-time lows of 0.2% while inflation, as measured by the consumer price index, is running at 2.7%, leaving the real rate at -2.5%. The ECB, which itself sets policy for 17 countries and just raised rates by a quarter point, has a real rate of -1.5%. At the extreme (and off this chart), Venezuela’s rate of 16.2% is far behind a roaring inflation of 28.7%, leaving real rates at -12.5%.

The other 22 central banks now have positive real rates (the blue dots), in most cases because they are tightening policy to get ahead of high inflation. Notably, China’s policy-makers recently raised rates for the fourth time in this cycle to 6.3% as inflation rose to 5.4%; the positive real rate of 0.9% might be followed by more hikes if inflation continues to head up. Brazil has been more aggressive, hiking rates to 12.0% as inflation accelerated to 6.3%, leaving real rates at 5.7%, well at the high end of the spectrum.

The global financial crisis spurred a concerted and joint effort across the world to restore global growth. After a historic synchronized slashing of interest rates, central banks are now starting to diverge. As some countries raise rates and drain excess liquidity, a negative real rate everywhere else is leaving the monetary spigots wide open. With so much stimulus still sloshing around the global system, it remains to be seen whether local policymakers can do enough on their own to contain the price pressures inside their economies. To the degree that higher inflation becomes a global problem, fixing it might require the eventual resynchronization of central bank policies.

Chart of the Week: Inflation By Any Other Name

At first glance, the inflation rate in the US appears to be quite different than in Europe. The Fed’s preferred measure is up just 0.9% from last year. The ECB’s measure is running at 2.7%, well above its mandate and was the trigger for the first hike in this cycle. However, appearances can be deceiving. The differences have less to do with the underlying price trends in the US and Europe than with how the price indexes are constructed.

In the US, the headline consumer price index is up 2.7%. Many economists prefer to strip out food and energy costs to get at the underlying trends, which puts the core CPI at 1.2%. The Fed’s preferred core measure is a broader index of personal consumption expenditures, the core PCE, which at 0.9% is above the recent historic lows of 0.7% posted in December but well below the Fed’s informal target of 2.0%. With that kind of data, a hike remains on the distant horizon.

In Europe, meanwhile, the ECB has an explicit target of keeping inflation below 2.0% as measured by the Harmonized Index of Consumer Prices. The March print of 2.7% was the fourth month in a row that inflation was above the target and prompted policymakers to hike rates despite the ongoing economic stresses in much of Europe.

The divergence in the data is largely a methodological artifact: Policymakers in the US and Europe are measuring different things. The core PCE strips out food and energy and it includes the cost of shelter, which has been a drag in the US. In contrast, Europe’s HICP keeps food and energy costs but excludes shelter, the reason being that the statisticians have been unable to devise a way to harmonize housing costs across the EU.

A few years ago, the US government constructed an experimental index that recalculates the consumer price index following the same methods used in the EU. The US HICP is currently up 3.3%, nearly quadruple the pace of the core PCE. If the Fed measured inflation the same way they do at the ECB, US rates might be going up too.

The core PCE is also out of sync with the rest of the world, with prices going up briskly everywhere from China to Canada to Brazil. Inside the US, producer prices and import prices are also heading up. Even other alternative core price measures show a sharper turn in the inflation trends, from the Cleveland Median CPI to the Atlanta Sticky CPI.

During the recession, US policymakers fought the specter of a deflationary spiral by bringing interest down to historic lows and then launched two rounds of quantitative easing. They have said they want to see inflation go higher before any policy tightening. It’s possible they already have it.