Interest rates are among the biggest tools used by the Federal Reserve or the Fed to influence the economy. Kavan Choksi mentions that the Fed can stimulate economic activity by lowering rates and making it cheaper to borrow funds. It can also slow the economy by raising interest rates and making credit more expensive. Increasing interest rates is a widely used strategy to fight inflation.

Kavan Choksi underlines how the Federal Reserve Monetary Policy can impact investments

Even though it is not entirely possible to exactly say how any investment shall perform at a given time, both expansionary and restrictive monetary policies do have quite real impacts on the general performance of diverse asset classes.

When the Fed is focusing on controlling inflation, it shall ideally raise interest rates. Distinctive asset classes shall react as follows to this decision:

• Bonds: An increase in interest rates ideally does not have a positive impact on bonds. Bonds usually pay a fixed yield to the investors on the basis of the interest rates they are issued at. In case interest rates go up, so will the bond rates. This basically implies that newer bonds will pay a higher fixed yield, thereby driving down demand for previously issued, lower yield bonds. As the demand for these bonds drops, so does the price these can be sold for.
• Equities: New fixed income investments with higher yields become more attractive to investors as interest rates go up. This may drive down the risk appetite of the investors, causing leading equities to underperform. Moreover, when inflation rates go up, speculation in regard to the rising costs of goods and services may cause an increase in market volatility. This can impact returns on equities.
• Cash: An increase in interest rates may result in higher deposit rates, ultimately making cash deposits more attractive to investors, as opposed to the times when rates are low. But in case the rate of inflation does rise higher than interest rates, investors may have to deal with the risk of not generating a positive real rate of return through cash holdings and ultimately could lose money.

In situations where the Fed is trying to stimulate growth, they ideally lower interest rates through quantitative easing. To this, asset classes may react as follows:

• Bonds: Lower interest rates generally have a positive effect on bonds. In case interest rates go down, existing bonds will likely pay a higher yield rate than newly issued bonds. This shall drive up demand for previously issued bonds, which ultimately provides a boost to the prices at which they can be sold.
• Equities: Equities have a tendency to overperform during periods of expansionary policy. Based on the extent of the actions of the Fed, purchasing certain securities types while simultaneously lowering interest rates, would make it easier for greater liquidity to enter the economy. This can result in an increase in stock prices.
• Cash: Low interest rates would mean that cash shall provide only minimal returns, therefore it becomes better for investors to avoid cash and cash equivalent investments.

As Kavan Choksi says, to avoid or at least lower risks the caused by changes in the interest rates, it is prudent to diversify the investment portfolio. A diversified portfolio would ideally have one subset of asset classes generate meaningful returns when others struggle during volatile market conditions.