Natural Rate of Unemployment

With the release of the most recent jobs report by the Bureau of Labor Statistics, the discussion of the headline unemployment number centered around the fact that unemployment had fallen to 5.5%, or equal to the so called "natural rate" of unemployment. With the rapid increase in hiring that has been seen over the past twelve months, an average jobs gain of 275,000 jobs per month, the unemployment rate has fallen substantially, reaching its lowest level since May 2008. Now that the unemployment rate has reached the natural rate level, the discussion around the Federal Reserve raising rates has increased. While the speculation is that the Fed will seek to take its foot off of the pedal of the economy to stabilize employment around this level, there may be benefits to increasing employment past the natural level.

Using the analysis of data provided by the St. Louis Federal Reserve Economic Database, there is an impressive relationship of the unemployment rate falling below the natural rate and the advent of a recessionary time period. A close analysis of the graph (below), shows that when the Civilian Unemployment Rate (red line) has fallen below the Long-Term Natural Rate of Unemployment (blue line), there has been a recessionary period. It is interesting to note that recessions further in the past, specifically ones before 1990, had significantly lower unemployment rates than the NROU before the onset of the recession. However, with the recent recessions, the unemployment rate has not been able to dip so far below the NROU before climbing with the economic contraction.

However, there has been increasing calls for the Fed to push the unemployment rate well below the natural rate level. Specifically, a paper from economics professor Laurence Ball at John Hopkins University argues that the fed should push the unemployment rate well below even the 5% mark. He argues that this recession is unique in that there are a significant number of long term unemployed and discouraged workers. His plan to push unemployment temporarily below 5% would help solve this problem:

It [the Fed] should seek to push the rate "well below 5%, at least temporarily," he writes. That could help bring some discouraged workers to reenter the labor market, as well as help the long-term unemployed find work and involuntary part-time workers find full time jobs, he said. "A likely side effect would be a temporary rise in inflation above the Fed's target, but that outcome is acceptable."

This is an interesting take on the economic issue that remains to be at hand, many years after the official end to the recession. While the headline number of unemployment, the U-3, has fallen significantly since 2010, other, more broad measures of unemployment such as the U-6 have not shown as much improvement. The plan that he suggests would be a greater focus on returning these more broad measures down to their "natural" levels. In addition, the side effect of an increase in inflation could be a positive for the economy. Currently, US inflation has been under the Fed's target for almost three years; for the Fed to come out and say that they are going to continue to pressure unemployment down, there could be an increase in expected inflation within the market, helping them get closer to their medium-term targets.

Liability of Fannie and Freddie

In a controversial move during the Financial Crisis, the United States treasury effectively took over home-mortgage companies Fannie Mae and Freddie Mac by placing them into conservatorships. The federal government took conclusive steps to do what it had implicitly done for years: use the US credit to stand behind the debts of these Government-Sponsored Entities. While many have viewed this act as overreaching on the part of the government, under the laws of agency, the government would have been liable for their losses anyway.

The history of Fannie and Freddie can help explain how the laws of agency can apply to these Government-Sponsored Entities. While technically not under the direct control of the government, the two corporations were originally founded by President Roosevelt and Congress to purchase mortgages from cash poor banks. As response to the Vietnam war, the two entities were spun off of the government's balance sheet and made publicly traded corporations. But, as David Wessel describes in his book In Fed We Trust, both Fannie and Freddie maintained implicit backings from the government:

Since 1972, they had been owned by shareholders and run for profit, but they borrowed all over the world at low interest rates because investors, including the Chinese government, assumed—correctly—that the U.S. government stood behind their debt, even though it didn't have any legal obligation to do so.

Wessel's conclusions about legal obligations notwithstanding, the point that he makes about the government standing behind Fannie and Freddie's debt is important in terms of agency law. Investors from around the world noted that these GSEs were closely liked to the government's pocketbook and made their investment decisions based on the implication of this implicit government sponsorship. From the standpoint of United States Agency law, this is an important characteristic of these entities acting as agents of the US government.

Under the structure set up by the US Government, the definition of Agency by Estoppel. Essentially, estoppel agency comes down to three criteria that can establish liability of principles by agents, all of which were met by Fannie and Freddie as agents of the US Government. The first is that the principle causes a third party to believe that an agent has an authority to act on the principle's behalf. In the case of Fannie and Freddie, the government originally set up the entities and they remained GSEs. The second criterion is that the principle has notice of the third party's incorrect belief but takes no steps to rectify the incorrect belief; this point is more contentious, but it seems reasonable that the government would have noticed the cheaply sourced international funding that the companies were receiving, and clearly they did not do say anything to deny their involvement with Fannie and Freddie (implicit or otherwise). Finally, the third party would justifiably change their position with the correct knowledge of the agent's lack of authority. This seems to be pretty clear with the corporations as lenders would have demanded a higher risk premium inline with corporate bonds as opposed to premiums more inline with government credit. Since both Fannie and Freddie meet the requirements of Agency by Estoppel, this would cause the government to be liable for their debts, regardless if they had been taken over or not.

Federal Reserve Reform

The Federal Reserve System was first established over 100 years ago with the advent of The Federal Reserve Act in 1913. While the landscape of the United States has changed significantly in that time, the formal structure of the Fed System has stayed remarkably the same. And while the Federal Reserve was initially created in response to a series of bank runs and financial crisis, we should leverage this most recent financial crisis as an opportunity to put forward structural changes that can help expand the scope of the Fed as well as ensure further political insulation.

The current Regional Federal Reserve bank system is the same structure that it was when it was founded in 1913. At this time, the US population was most heavily concentrated in the Eastern portion of the country and, with a population of approximately 97 million people, each Federal Reserve oversaw an average of approximately 8.1 million Americans. The population changes over the 100-plus years since is the underlying argument for change as proposed by John R. Dearie in his WSJ article The U.S. Needs Two More Federal Reserve Banks. He points out the US has undergone a great change in its population make-up:

The Census Bureau has estimated that as of 2014, 42% of the population—and, presumably, a similar portion of economic activity—resides west of the Mississippi River. This simple metric suggests that if the interests and priorities of the entire nation are to be represented in monetary policy deliberations, at least five regional Reserve Banks should now be in Western cities.

He goes on to explain that there would be too much political turmoil in attempting to relocate a regional Bank and instead proposes expanding the number from 12 to 14 Banks, installing two new locations in populous cities in the Pacific Northwest and the Southwest. While the changing population distribution might be important for additional banks in the West, a simple analysis of the total US population might suggest the need for even more regional Reserve Banks. The current US population is approximately 320 million, a 230% increase from the 1913 drawing of the Federal Reserve map. Compared to a 0% increase in regional Fed Banks, there appears to be a disconnect; to keep the same 8.1 million per Bank proportion, there would need to be about 40 regional Banks. I do not suggest that the 40 number would be correct, as the advent of the television and (more importantly) the Internet has made it significantly easier for economic information to be collected/shared. Possibly the addition of four new regional banks in areas such as New Orleans, Seattle, Los Angeles, and Denver, would help solve the total population and population distribution problems.

Another structural proposal change has to do with the Chair position of the Board of Governors of the Federal Reserve System. Specifically, the current four year term of the Chair leaves this important Fed figure open to political influences. A Washington Post article describes the ever changing relationship between the Chairman and the President:

Many aides in the Reagan administration were frustrated with Paul Volcker's tight money policies, and Volcker took holy hell from home building industries and others stung by high interest rates...The tension between the George H.W. Bush administration and Greenspan was legendary. But the last three presidents—Clinton, George W. Bush, and Obama—have settled into a more agreeable routine with the Fed, in which they do not comment on monetary policy or try to explicitly tell the central bank what to do.

While the past three presidents have taken a more hands-off approach, relying on this goodwill to continue is not an extended long term plan for politically neutral central banking. In addition, as it may take a significant amount of time for monetary policies to take hold in the real economy, the short term periods of the Chair position may result in political pressures removing this individual from power before policies can be carried out. An important structural change to moving the term periods to six or eight years, may go a far way in insulating this decision maker from undue political pressure.

Investing on an Infinite Time Horizon

Two weeks ago when my parents met with their retirement adviser, he recommended that they reallocate some of their stock portfolio into bonds as they are drawing ever closer to their retirement age. My father, familiar with my knowledge on finance and markets, consulted me about the move before making his final decision: I ended up agreeing with the adviser's assessment for allocation away from risk. However, it occurred to me that it is kind of silly that they should miss out on this potentially lucrative investment returns of the stock market simply because their age dictates they should seek low risk, capital sustaining investments. It got me wondering if it was possible to ignore the Life-Cycle Theory and achieve more optimal investment choices. Specifically, if the investment time horizon is infinite, the risk of holding stocks is essentially eliminated and "excess" returns can be made.

The idea of life-cycle investing can be described by Burton Malkiel in his book A Random Walk Down Wall Street. Malkiel, like most life-cycle investors, concludes:

It is this fundamental truth that makes a life-cycle view of investing so important. The longer the time period over which you can hold on to your investments, the greater should be the share of common stocks in your portfolio. In general, you are reasonably sure of earning the generous rates of return available from common stocks only if you can hold them for relatively long periods of time.

Malkiel also includes the following chart for those who would like to visualize this concept:

By defining investment "risk" as the standard deviation of average return, there seems to be some form of risk-mitigating that can come from holding stocks for a greater amount of time. The ability to hold stocks for 25, 50, possibly even 100 years would allow investors to continue to reduce the standard deviation of their average annual returns, potentially even eliminating it.

However, the definition of investment risk may not be appropriate, as the followers of the Fallacy of Time Diversification argue. Their argument holds that investors do not care about their "average returns" but on the ending value of their portfolio; and while the average return can be useful to calculate where a likely portfolio value will be, they prove that the variance inherent in stock returns actually increases the range of ending portfolio values. Peter Haggstrom uses math to show how, when total return is considered, time actually increases risk:

Unwittingly some proponents of the argument may be signing up to the following claim: standard deviation of the annualised return = standard deviation of the total return. For a time scale of more than 1 year, this equation is false...

       

This bit of math proves that as the time horizon increases (t increases), so too does the standard deviation of total return. However, while it may be true that investors seek to maximize their ending portfolio value given a finite time period, if investors were to consider their time horizon as extending infinitely into the future, this problem goes away. In a continuously compounding portfolio, where the ending value of the portfolio is defined as the sum of all returns on the portfolio between time 1 and time t, when t goes to infinity so too does the value of the portfolio. Not only is there not an "ending point" of the portfolio to maximize against, but there is no ability to maximize (since it is infinity).

The question now returns to what function that investors should seek to maximize, given that their "original" portfolio value function cannot be maximized. It now makes sense that investors should seek to increase the rate at which they are moving toward this infinite portfolio value; or, in other terms, they should seek to maximize the average sum of all returns on the portfolio between time 1 and time t. Once again, we have returned to the maximization of rate of return (which has already been proved mathematically have reduced, and even eliminated, risk when there is an infinite time horizon). Investors, while seeking to maximize this rate of return, should increase their holding of those assets which have historically produced the highest returns; if you constrain these investment options to only stocks and bonds, it would make most sense for these infinite time horizon investors to hold 100% in equities at all times.

Rethinking Ross: A Response

While I have no doubt that my views on the subject skew toward the positive direction, I feel as though the Ross School of Business has gained an exceedingly bad reputation on the University of Michigan campus. Entitled, arrogant, exclusive, competitive, are all words thrown around to describe the typical "Ross" student. This was exactly the picture of the Business School painted in a recent Michigan Daily Statement article titled Rethinking Ross. As a member of the Ross community, I take issue with being stereotyped and painted as "un-diverse" and all about "chasing the dollar"; where the Business School and its students get blamed for these supposed flaws, the conversation should be shifted to their solutions.

There is a perceived, and actual, lack of diversity within the Ross School of Business and, more generally, in business programs. This idea is highlighted in the Rethinking Ross piece:

There are plenty of opportunities for the Business School to grow, but perhaps none are more measurable as the lack of diversity in the program. In the most recent cohort of accepted students, just 4 percent of the Business School bachelor's degree program identified as an underrepresented minority. More remarkable is that that number is actually an improvement from each of the last two years.

This lack of diversity also stems further from just underrepresented minorities; the full BBA student profile indicates that only approximately 41% of accepted regular admissions students are female. The accepted discourse on the diversity topic around business programs is to blame them for this lack of diversity, essentially implying that business programs intentionally discriminate against minorities. However, there may be an underlying selection bias that can account for a great deal of this apparent marginalization.

A Wall Street Journal article titled Business Schools Short on Diversity outlines the selection bias that is apparent in the business school application process. They point out:

Enrollment number are only part of the issue, schools contend-applications from underrepresented groups are also low. Most schools don't break down their application data by race, but admissions consultants and other business-school insiders say those groups remain underrepresented in application pools too.

While there is know way of knowing exactly how much of the lack of diversity is explained by the lack of diverse applicants without the schools releasing the data themselves, it is clear that is has a significant impact on enrollment diversity. Opening up the conversation on encouraging these minorities to apply in greater numbers to business programs can have a significant impact on driving greater diversity in actual enrollment. Policies specifically designed to target and encourage minority group's interest in business can be much more effective than blaming business schools for discrimination.

In the same sense of shifting the conversation on encouraging minorities, there should be further conversations on discouraging those who attend business schools for job opportunities. While job security can definitely be a significant deciding factor for students who are choosing a major, it seems as though students are increasingly placing too much weight on this factor, causing them to feel dissatisfied with their coursework. Again, the Michigan Daily Statement article explains by interviewing a student and concluding:

"If your motives aren't right, like mine weren't—I saw dollar signs when I saw Ross"...[Faculty] also notice that, despite the favorable job and compensation prospects, business majors are regularly reported as among the least happy in school and the workplace nationwide.

One such example of this is a report from Business Insider which analyzes college majors that lead to jobs that are considered meaningful by the people who hold them; in the top 20 majors listed, not a single business discipline can be found. While the logical conclusion is that business is a dry, uninteresting field of work and study, I believe students find less satisfaction because they placed job placement as a deciding characteristic of choosing a major. Plenty of my colleagues in the business school, myself included, actually enjoy business courses; specifically my passion for financial markets was largest consideration in my application to the business school—job security was simply an added bonus. Creating conversations to downgrade the importance of job placement and upgrade the importance of satisfaction can realign the incentives and decision making process, potentially discouraging those who would have been miserable simply "chasing the dollar".

A Random Walk Spoiled

As a golfer, you learn early on the old adage of Mark Twain: "Golf is a good walk spoiled." While Twain was harsh on the sport of golf, Burton G. Malkiel was equally harsh on the world of investing in his book A Random Walk Down Wall Street. Malkiel attempts to "spoil" some of the old, strongly held notions about stock market investing: specifically that individuals (and more importantly) fund managers cannot outperform a broad basket of diversified stocks over the long run.

He shows that old techniques of technical analysis—using charts and movement analysis to predict future stock movements—and fundamental analysis—using projections to project some sort of growth rate to give an "actual" value of a company—simply do not give excessive returns. Malkiel continues in his argument putting the test to supposed market anomalies that have created significant returns in the past. Such anomalies, such as the "January Effect", the "Dogs of the Dow", or the "Monday Afternoon effect", are also proven to fail in the face of increased scrutiny, especially when trading costs and short-term taxes are taken into account.

I have a tendency to agree with much of what Malkiel says. On the point that there is no "magic" formula that will allow investors to somehow earn excessive returns consistently. The idea seems to collapse on itself: as soon as it is widely accepted by the market, the anomaly will be traded out of the market as investors attempt to preempt is movement. I also agree with his harsh words against technical analysis, but the points he uses to illustrate this are interesting. He illustrates the fact that people cannot understand random patterns by looking at a classroom experiment involving coin flips, showing that people try to use probability to explain something that they cannot understand.

However, I disagree with Malkiel's opinions on fundamental analysis. It seems as though Malkiel holds a double standard when comparing supposed "efficient" markets and the returns of those relying on fundamental analysis. Malkiel outlines his five rules for why security analysts have trouble predicting the future:

(1) the influence of random events, (2) the producing of dubious reported earnings through "creative" accounting procedures, (3) errors made by the analysts themselves, (4) the loss of the best analysts to the sales desk or to portfolio management, and (5) the conflicts of interest facing securities analysts at firms with large investment banking operations.

The most important factor that I take issue with is the first factor. He handicaps the work of the equity researcher to the random movements of the markets, explaining how a significant portion of poor performance of the predictive power of equity researchers is due to the pure random movement of the market. However, when taken in the prospective of the market as a whole, this random movement only indicates an increased risk and only provides the added benefit of increased returns for the amount of risk. It does not make sense that a penalty for the equity researchers should be a benefit for followers of efficient markets.

Revised: The Real (Estate) Cost of Student Debt

It was reported by the Institute for College Access and Success that 69% of graduating seniors in 2013 had debt levels, averaging $28,400 in student debt. While repayment of principal and interest on these loans themselves can be expensive, one of the hidden expenses is the opportunity cost of having this student debt amount, namely sub-optimal investment choices. One area of investment choices that are distorted due to accumulating student debt is in the real estate market: increased debt levels force recent graduates to forgo purchasing real estate assets. This impacts them on two fronts, first it limits their portfolio exposure to potentially lucrative investment returns and causes them to pay for relatively more expensive rentals.

As pointed out in A Random Walk Down Wall Street, an investment into hard real estate assets such as houses can provide excellent returns into a well diversified portfolio. Burton Malkiel explains:

As long as the world's population continues to grow, the demand for real estate will be among the most dependable inflation hedges available. Although the calculation is tricky, it appears that the long-run returns on residential real estate have been quite generous...In sum, real estate has proved to be a good investment providing generous returns and excellent inflation-hedging characteristics.

It makes sense that recent graduates would want to invest into such an asset class to better ensure they are able to take advantage of the long run returns that Malkiel describes. However, as more and more students are graduating with expanding college debt levels, they are increasingly unable to afford the purchase of a house. A 2013 post by Liberty Street Economists on the New York Fed blog analyzed the impact of student loans on home ownership. They explain their findings from the graph (below):

By 2012, the homeownership rate for student debtors was almost 2 percentage points lower than that of nonstudent debtors. Now, for the first time in at least ten years, thirty-year-olds with no history of student loans are more likely to have home-secured debt that those with a history of student loans.

In the past, those aged 30 with college debt were more likely to purchase a home due to their greater propensity to acquire higher paying jobs and thus be able to afford home ownership. However, this relationship has changed starting in 2012, possibly due to the higher overall levels of debt precluding mortgage approvals and reducing already debt burdened individuals ability to make home payments. The advent of this increasing proportion of students with debt and higher overall debt levels has been a contributing factor in the fall of home ownership, potentially leaving a large portion of recent graduates investment portfolios underexposed to the real estate sectors.

Not only are debt-burdened students under-investing in home ownership, they face increased relative prices for renting. A WSJ article entitled A Tough Time for Renters, outlines the rapid rise in rental prices:

The cost to rent an apartment jumped in 2014 for the fifth consecutive year as strong demand and short supply left vacancies at historically low levels. Nationwide, apartment rents rose an average 3.6% last year...the average monthly lease rate to $1,124.38, the highest since Reis started tracking the market in 1980.

A calculator provided by the New York Times allows one to compare the relative costs of renting vs home ownership based on a variety of input factors. Using the standard assumptions given along with with an average 30-fixed rate mortgage of 4.00%, the equivalent home price to the national average monthly lease rate would be roughly $311,000. Given this is higher than the $199,600 national median sales price of existing homes, clearly the cost of renting currently greatly outpaced the cost of purchasing a home nationally.

However, the national data can skew the renting data, as rental rates will be especially high in areas of high populations such as large cities. Using a similar process to the NYT, online residential real estate company Trulia estimates the percentage difference in the cost of renting vs. buying a house in populous metropolitan areas. Their interactive map indicates that even in heavy populated areas, the cost of home is significantly less than that of renting, including a 21% difference in New York and Los Angeles, a 29% difference in Boston, and a 42% difference in Chicago.

All else being equal, this relative cost increase should tip the scales toward home ownership; however, as discussed above, the increased student debt levels have precluded individuals from home ownership. Not only are they missing out on the investment opportunity of real estate, they are throwing away relatively more money into the rental market.

Full Employment, Fed to Tighten

And we're back! After a Spring Break hiatus to Hilton Head, South Carolina, the blog posts will once again start flowing, so hold on to your hats.

This past Friday, the Bureau of Labor Statistics released its updated employment situation for February 2015. And while I was busy all day driving back from South Carolina, economists were busy all day analyzing the report. The general consensus was that the seasonally adjusted 295,000 jobs added and reported 5.5% unemployment rate indicates that there is full steam ahead for the labor market. However, as I have previously written, the true story of labor market slack is in wage growth. Once again, this jobs report included dismal real wage growth, with a slow down to 2% annual wage growth from 2.2% in January. While this headline may give pause for concern, further analysis reveals that wage growth may not be as bad as once thought. Given this employment situation, the Fed is perfectly placed to begin monetary policy tightening.

The story of wage growth is one of the last few indicators for labor market slack, and this labor report indicates that this story has only worsened. However, looking deeper into the numbers provided can paint a more positive picture of the labor situation. As explained by the chief economist at OppenheimerFunds Jerry Webman to The Street, the use of an average hourly wage can skew wage data. He explains:

"It's hourly earnings, so it's not everyone in the labor force," said Jerry Webman, chief economist at OppenehimerFunds. "Secondly, it's very much affected by who gets jobs as opposed to who doesn't get jobs...So it's not as if people are making less--it has something to do with the share of jobs we did create."

The use of this hourly wage number can be skewed as those who are entering the labor force, who may be hired in lower paying jobs due to lack of experience or lack of high paying job openings, will drag down the headline number. This average number can hide the growth in wages that have remained in the labor market over comparison periods, something that could show the true change in wage growth and give a better picture of the labor market. Factoring out these lower wage, new hires, should result in a greater overall wage growth for those who have been employed for a longer time period.

With the last factor of labor market slack seemingly not as bad as once reported, the Fed has signaled that they will be taking their foot off the stimulus gas. With the labor market now within the Fed described 5.2% to 5.5% range of natural unemployment rate, the Fed has cleared one of its last hurdles in beginning to raise interest rates. This final confirmation of expected monetary tightening sent a shock through financial markets after the report was released. As described in the WSJ Article Brisk Jobs Growth Puts Focus on Fed, equity markets and bond markets slumped following the Friday data release:

The prospect of Fed action jolted investors Friday, pushing stocks down and bond yields up sharply. The Dow Jones Industrial Average slid 278.94 points, or 1.5%, to 17856.78. The 10-year Treasury yield rose to 2.239%.

It is interesting to note that this jobs report seemed to be the final nail in the coffin for those investors holding out that the Fed would delay raising rates. It had been mostly expected that the Fed would begin to tighten its monetary stance during Summer 2015, and this jobs report only solidified this expectation further. It is clear that while the interest rate increase is largely factored into the market, when the Fed does decide to make its monetary move it will likely be a jittery time in financial markets as investors continue to adjust to ever changing interest rate environments.