The US Federal Reserve’s reversal of its dovish stance last December to a more hawkish position following its meeting last week, coupled with Fed chairman Jerome Powell’s explicit statement over the weekend that there will be no interest rate cuts soon, may be forcing investors to avoid timing the market and focus on long-term asset allocation.
The situation may also be prompting investors to do asset allocation as if there would be a recession and no soft landing of the US economy.
In practice, this would mean forgetting about tactical asset allocation, avoiding timing the market or trying to predict when the Fed will start cutting interest rates and focusing on long-term strategic asset allocation. It also means diversification across asset classes, using index funds, and regular rebalancing of the portfolio – like every three to six months.
This rather textbook recommendation is still the best way to protect the portfolio against a surprise recession.
While the Fed’s sudden reversal of stance caught some market watchers by surprise, it reassured others who thought that by being too dovish, and cutting interest rates too soon, the Fed would been risking a resurgence of inflation in order to achieve a soft landing of the US economy.
“The Fed’s mandate is to return to price stability and full employment, not to achieve a soft landing of the economy or to avoid an economic recession. If they can achieve a soft landing, that would be great, and I will be the first to congratulate them but that is not their mandate,” says Mark Higgins, founder of Portland-based Enlightened Investor LLC and author of “Investing in US Financial History”, published by Greenleaf Book Group Press.
While the Fed’s reversal, along with Powell’s latest statements, reassures Higgins that the Fed is not compromising on its original mandate of maintaining price stability in exchange for achieving a soft landing of the economy, the risk here is that by insisting on price stability there’s a chance the Fed can push the economy into a recession.
Returning to price stability means bringing down inflation to the Fed’s target of 2%. The annual inflation rate in the United States went up to 3.4% in December 2023 from a five-month low of 3.1% in November, higher than market forecasts of 3.2%, as energy prices went down at a slower pace.
“The question really should be, has anyone avoided a recession after a long period of price instability? Has anybody navigated a return to 2% inflation without causing a recession? There aren’t many comparables here,” Higgins says.
Asked in a weekend interview why the Fed has not yet cut interest rates when inflation has already come down, Powell says, “We think the economy's in a good place. We think inflation is coming down. We just want to gain a little more confidence that it's coming down in a sustainable way toward our 2% goal.”
“The danger of moving too soon is that the job's not quite done, and that the really good readings we've had for the last six months somehow turn out not to be a true indicator of where inflation's heading. We don't think that's the case. But the prudent thing to do is to just give it some time and see that the data continue to confirm that inflation is moving down to 2% in a sustainable way,” Powell says.
Powell does not rule out the probability of a recession, but he stresses: “We have to balance those two risks. There is no, you know, easy, simple, obvious path. We have to balance the risk of moving too soon or too late. And there are different risks.”