My mother-in-law is not a doctor, but she has a home remedy for everything. Anytime I am sick or in any type of discomfort, she whips up some type of herbal drink or ointment. My wife says that this has always been the case, going back to her childhood. Sometimes they work, and sometimes they don’t. Typically though, they are foul-tasting and smelling. When they do work in curing my affliction, it is likely more of a placebo effect than good science, but results are results (and of course all due credit is given to my mother-in-law). Naturally, I only succumb to her home remedies when my condition is not anything serious, such as a cold or mild sunburn. For anything more serious than that, I head straight to my doctor’s office.
My mother-in-law and Federal Reserve Chairman Ben Bernanke have one thing in common. Neither one of them is a doctor—well, in Mr. Bernanke’s case, not “that kind of doctor.” Ben Bernanke is, in fact, a doctor as he received his Doctor of Philosophy in economics from MIT in 1979. Despite that indisputable fact, I would show up on my mother-in-law’s doorstep before visiting Dr. Bernanke at his Washington, D.C. office for medical treatment. Obviously, not being a medical doctor, he doesn’t have the necessary tools—education, experience, medical license—to perform that kind of service (and being a man of science he’s probably not a big believer in home remedies). While it seems unlikely that anyone would ask Dr. Bernanke to treat their illness, he and his colleagues at the Federal Reserve are being asked to treat an economic malady for which they lack the necessary tools to fix.
Cyclical vs. Structural Unemployment
The Federal Reserve has the dual mandate of full employment and price stability—keep unemployment near its natural rate and inflation manageable. But there are two types of unemployment—cyclical and structural. Cyclical unemployment is the natural ebb and flow of employment as a result of the business cycle. In good times, businesses hire, pushing the unemployment rate down. In lean times, businesses cut costs by cutting jobs, and the unemployment rate rises. Structural unemployment results from a disparity in the skills, education, and experience of unemployed workers and the requirements of the open jobs in the marketplace.
The Fed has tools to battle cyclical unemployment but not structural. You fight cyclical unemployment with easy monetary policy. Lower interest rates to get the economy moving and encourage businesses to spend, invest, and borrow, which ultimately leads to them hiring again. But, the reason today’s unemployment rate refuses to budge despite historically loose monetary policy is because we are facing unemployment that is largely structural in nature.
With an unemployment rate hovering around 9%, it should theoretically be easy for employers to fill vacancies. Yet, according to McKinsey Global Institute’s June report entitled, “An Economy that Works: Job Creation and America’s Future,” which surveyed 2,000 U.S. companies, nearly two-thirds of respondents reported difficulty in filling job openings, and 40% had open positions for at least six months due to an inability to find suitable applicants. Anecdotally, our small business has experienced the same frustration in hiring this year in that it has proven much more difficult and took much longer to fill positions than one would expect in an economy with 9% unemployment.
Asking the Fed to cure unemployment when it is largely structural is like asking Dr. Bernanke to cure a throat infection. They simply don’t have the necessary tools to fight it. As we have witnessed, loose monetary policy does little to help the situation when the skill set of the unemployed does not match companies’ demands. Cures for structural unemployment include training initiatives, education programs, and incentives for businesses to hire those who have been out of work the longest—all of which fall outside the Fed’s domain.
What Should Investors Do?
Regardless, the Fed has to try to fulfill its goal of full employment the only way it knows how and the only way it can—via easy monetary policies. The end result will be above average inflation (already running at 3.8% versus a 3.1% historical average) and a stubbornly high domestic unemployment rate, unless Congress quickly addresses the structural issues at hand. For investors, the implications are as follows:
- Invest in bonds defensively by avoiding Treasuries, which do not yield enough to cover present or the projected future rates of inflation. Instead, focus on bonds that provide current yields above inflation (i.e. intermediate-grade corporates, high-yield, munis for high income earners, and emerging market bonds).
- Maintain at least a portion of your portfolio in growth assets like equities, commodities, and real estate that provide an expected return more likely to outpace inflation than bonds.
- Get comfortable with the idea of investing in risk assets despite a high unemployment rate, something that has been difficult to reconcile for many of our clients. There is no correlation between changes in the unemployment rate and future equity returns.
- Given the high volatility in the market recently, drink a glass of water with lemon and sugar for an uneasy stomach. (That tip is from my mother-in-law.)