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Why interest rate risk matters

Rising interest rates could cause lots of assets to fall at the same time. Luckily, there's a simple way of protecting ourselves from this.
Why interest rate risk matters

Many of you are worried by the possibility of higher inflation. What should worry you more, though, is something else – the danger of higher interest rates.

I say this because it is in principle easy to protect ourselves against inflation – albeit at a cost – simply by buying index-linked gilts. The problem is that doing this would not work if the Bank of England were to raise interest rates significantly, or if markets were to expect them to do so. If this were to happen, index-linked gilt yields would rise, imposing capital losses upon anybody not planning on holding them to maturity.

Note that the issue here is real interest rates. Because it is these that tighten monetary policy, the Bank would have to raise rates by more than the rise in inflation if it wanted to reduce inflation.

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