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The Federal Reserve announced today that it will maintain its short-term interest rate within the range of 4.25% to 4.5%. Federal Reserve Chair Jerome Powell described the economic outlook as “highly uncertain” but also noted that the economy remains stable. On the positive side, unemployment is low at 4.2%, which Powell characterized as being near maximum employment, fulfilling the Fed’s first mandate. The second mandate, inflation, remains elevated but manageable at 2.3%, according to Personal Consumption Expenditures (PCE) inflation data from the Bureau of Economic Analysis. The Fed’s target for inflation is 2%, meaning that inflation is slightly above target but not alarmingly high.

Given these conditions, the Federal Reserve’s decision to hold interest rates steady is consistent with its approach of responding to existing data rather than acting proactively. Both employment and inflation are within acceptable ranges, justifying the current policy stance.

What Should Investors Do?

Investors, like the Federal Reserve, should maintain caution. Predicting the future is difficult, and while the Fed has the flexibility to cut rates if economic conditions worsen or raise them if inflation accelerates, investors should prepare for a range of possible outcomes.

One scenario that investors must be prepared for is stagflation – a combination of stagnant economic growth, high inflation, and rising unemployment. Should this occur, Powell indicated that the Fed would conduct a cost-benefit analysis to determine the most appropriate policy response, even if it means making difficult trade-offs between employment and price stability. You can read the article that I published earlier on the risk of stagflation here: “Is stagflation around the corner?”

The Biggest Uncertainty: Exogenous Factors

Currently, the most significant uncertainty for the economy comes from exogenous factors such as trade policies and immigration laws. These policies can change rapidly, sometimes even before their scheduled implementation dates, creating high volatility and unreliable data for economic forecasting. This uncertainty may dissipate in a few months, leading to low inflation and strong economic growth, which will be favorable for stocks but challenging for gold. Also, considering that gold has already rallied by 26% YTD as of May 7th 2025. Alternatively, prolonged uncertainty could trigger a negative feedback loop, where declining consumer confidence reduces spending, further slowing growth.

Consumer Spending and Its Economic Impact

Consumer spending accounts for approximately 68% of U.S. Gross Domestic Product (GDP). In the first quarter of the year, consumer spending surged, partly due to expected price increases from tariffs. This increase in spending was likely temporary. In addition to the reversal of consumer spending, the rising anxiety and weaker economic growth could cause future consumer spending to decline significantly, further pressuring the economy.

Diversification and Asset Allocation

Maintaining a diversified portfolio with an appropriate asset allocation is critical. Based on my recent research paper, “Asset Allocation Based on 20 Years of Market Data,” certain asset classes have demonstrated strong risk-adjusted returns in recent years. These include:

These asset classes may offer valuable diversification benefits in a volatile market environment.

Yield Curve: A Reliable Recession Signal?

The 10-Year vs. 3-Month yield spread has recently returned to flat territory. Historically, since 1982, each time this spread inverted and then reverted to positive, a recession has followed (see Chart 1).

Meanwhile, the 10-Year vs. 2-Year spread has steepened significantly. One explanation for this steepening is that investors are buying short-term bonds more aggressively than long-term bonds, possibly due to concerns about inflation and government debt sustainability (see Chart 2).

Long-term bonds face a dual challenge:

One way to mitigate this risk is through Treasury Inflation-Protected Securities (TIPS), which offer inflation-adjusted principal. However, TIPS are still susceptible to losses if interest rates rise.

Conclusion

The economic outlook remains uncertain, with the Federal Reserve maintaining a cautious stance and being prepared to react to what lies ahead. Investors should focus on diversification, stay informed, and recognize that the future may differ significantly from the present. Past performance of asset classes may not predict future success (Asset Allocation Based on 20 Years of Market Data). Therefore, maintaining an asset allocation strategy that accounts for inflation and provides a positive risk-adjusted return, consistent with your risk tolerance and return objectives, is essential.

References

Disclosures:
This analysis is based on historical data and forward-looking estimates that may not materialize. This content represents the author’s opinion only and is not guaranteed to be accurate or complete. Please consult a qualified financial advisor before making any investment decisions. Neither ECNFIN.com nor the author assumes liability for any actions taken based on this information. Past performance is not indicative of future results.

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