How do higher interest rates affect inflation?

The 13th interest rate increase since May 2022 has re-ignited the debate about the use of higher interest rates to fight inflation.
Interest rates and inflation

Yesterday, the Reserve Bank of Australia raised interest rates for the 13th time since May 2022, based on inflation.

That decision, which ended a four-month streak without rate rises, has re-ignited the debate about how higher interest rates affect inflation.

Here’s a refresher.

The basics of inflation

High inflation means prices are rising quickly. This has adverse consequences, including increasing the cost of living.

Generally, high inflation happens when there is an imbalance between what we want to buy (demand) and what is available (supply).

One way to think about that situation is that there is ‘too much money’ for what is available. As people compete with one another to buy what is available, prices go up.

The simplest way to think about it is to focus on one market, like housing. If everybody suddenly had twice as much money to spend on housing (more demand), they would compete with one another to bid up the price of housing.

The same thing would happen if half of the available houses suddenly disappeared (less supply), as people would bid up the price of the remaining houses.

Inflation is like that, but applied to all prices across the economy. In 2021 and 2022, inflation across the world was sparked by a global supply chain problem (less supply), and accelerated by the fact that many people had saved money during COVID lockdowns and spent a lot once lockdowns were over (more demand).

However, regardless of which ‘side’ the imbalance comes from (in this case a bit of both), the solutions tend to focus on reducing demand. That’s because it’s hard to quickly fix a supply shortage, but it’s easier to cut demand — by taking money away from people.

The role of interest rates

This is where interest rates come in. Higher interest rates make borrowing money more expensive, which discourages spending.

The most obvious way this happens is by pushing up the mortgage repayment rates of homeowners (which discourages them from spending more money elsewhere). It also affects businesses who borrow money.

The consequences of higher interest rates

Higher interest rates have two notable side-effects.

One is that they hurt some more than others. Someone with a mortgage will be hit much harder than someone who owns their home outright, or someone who has no assets or debt.

The other is that less spending means less revenue for many businesses, which can trigger job losses and business closures.

The debate

The first issue (the distribution of pain) is something governments can change by tweaking tax or welfare policies.

The second issue (job losses) leads to a heated debate over the RBA’s interest rate strategy. The question is: do the benefits of fighting inflation outweigh the consequences for the economy?

So far, higher rates have cut back inflation without many job losses. However, each extra rate rise heightens the risk to jobs.

The role of inflation expectations

So why did Bullock raise rates? One reason is to manage people’s expectations about inflation.

Expectations are very important. If everybody expects prices to keep rising, they may choose to bring forward their spending to get ahead of higher prices. In that way, expectations can become self-fulfilling.

To avoid this, the RBA will sometimes raise rates to send a ‘signal’ that it is serious about fighting inflation.

If that signal works, the RBA might not have to raise rates much further. Every time it does, the risk of triggering widespread job losses increases.

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