Two major events passed in quick succession in late August: the Bank of Korea's back-to-back rate increase and hawkish remarks by Federal Reserve Chair Kevin Warsh at the Jackson Hole meeting, casting himself as an inflation fighter. To understand why central banks are holding to a high-rate stance or signaling further increases despite various concerns, we first need to look at their fundamental legal mandates.
The four pillars that drive a macroeconomy are gross domestic product, prices, interest rates and employment. Central banks are given a legal mission to manage these in harmony and promote economic growth. The approaches taken in Korea and the U.S. differ. Article 1 of the Bank of Korea Act specifies a single mandate — "price stability through monetary and credit policy" — as the top priority, with "financial stability" listed as a matter to be taken into account. As the "price stability" plaque hanging in the Bank of Korea lobby suggests, curbing inflation and managing household debt are the foremost tasks. The Federal Reserve, by contrast, sets out "maximum employment, stable prices and moderate long-term interest rates" side by side under Section 2A of the Federal Reserve Act. In practice, the Fed carries out a "dual mandate" that weighs both employment and prices.
The Bank of Korea's back-to-back rate increases can be read as fulfilling that top-priority mandate — preempting demand-side price pressures arising from solid growth on the back of a semiconductor boom, along with the buildup of household debt, or financial stability. The Fed, likewise, left the door open at Jackson Hole to further rate increases in order to bring prices firmly under control, backed by robust employment data. In the end, central banks are unlikely to shift the direction of monetary policy easily until they see confirmation of "price stability," their core mission.
To cope with a prolonged period of high rates, individual investors need to adopt a fresh asset allocation strategy. In bonds, it is advisable to secure interest income through high-yielding short-term bonds and then, once the ceiling on rates becomes clear, to build positions in long-term bonds in stages, aiming for capital gains when rates eventually fall. Taking liquidity and transaction costs into account, short-term bond exchange-traded funds and 30-year bond ETFs can be good options.
In equities, portfolios need to be rebuilt around stocks with solid cash flow, stable dividends and pricing power. For those who find stock selection difficult, products that generate periodic cash flow, such as covered-call ETFs, are a good alternative. Reduce excessive leverage, and keep a certain level of cash so that quality assets can be picked up during market corrections. Not fighting the direction of central bank policy is the key principle in a monetary tightening cycle. Understanding the fundamental mandates of central banks and taking a long view of a period of policy change can turn a rate-hike cycle into an opportunity to lift a portfolio to the next level.
