How does raising interest rates help inflation?

When the cost of your favorite coffee begins to climb or you notice a spike in your weekly grocery bill, you're experiencing inflation. While inflation typically exists when it begins to outpace economic growth, adjusting the interest rate is one of the measures policymakers can apply to help lower inflation. But how does raising interest rates help to ease inflation? Let’s find out.

What causes inflation?

Put simply, inflation is the rate at which the prices for goods and services rise over time and it's an important economic indicator.

High inflation can often be a result of an imbalance between supply and demand. For example, when demand for products and services starts to outpace supply, prices go up — leading to higher inflation. On the other hand, if supply begins to outpace demand, prices might decrease and cause the inverse effect, called deflation. Rising costs of production may also inflate prices by making it more costly for businesses to make products or provide services. Production costs are then passed on to the consumer.

While inflation sometimes has a negative connotation, mild inflation is considered normal – possibly even beneficial. This is because it often accompanies an environment of higher spending, investment and economic growth. Problems may arise when the cost of goods accelerates unexpectedly. Sudden, sharp rises in prices can potentially affect economies by reducing the purchasing power of the currency.

Inflation and interest rates

Central banks often adjust interest rates according to inflation. Raising and lowering interest rates may help manage inflationary pressures on the economy. But why and how do interest rates affect inflation?

Essentially, interest rates are the cost of borrowing money. When the central bank increases interest rates, borrowing becomes more expensive. In this environment, both consumers and businesses might think twice about taking out loans for major purchases or investments. This slows down spending, typically lowering overall demand and hopefully reducing inflation.

Higher interest rates might encourage consumers to park more of their income in safer interest-bearing accounts, such as a savings account or CD. This typically decreases spending as well, potentially reducing inflationary pressure on prices.

On the flip side, lowering interest rates makes borrowing cheaper, encouraging spending, borrowing and investing. This action can be a useful stimulus for the economy, especially when governments and central banks want to encourage economic growth. Central banks use interest rates as a tool, helping to influence behaviors to heat up or cool down the economy as needed.

The role of the Federal Reserve Bank in controlling inflation

Managing interest rates and inflation for an economy is a delicate balancing act — one in which the Federal Reserve Bank, the central bank often referred to as “the Fed,” plays a pivotal role.

The Fed's decision-making is often driven by two key goals: promoting healthy employment levels and supporting price stability. Balancing these two involves always keeping the question of interest rates vs. inflation in mind. For example, if inflation is running hot and prices are rising rapidly, the Fed might raise rates to try to temper it — while keeping a close handle on just how “cool” the economy is becoming. If the economy starts to slow down too much, however, employment rates may suffer.

In a way, the Fed’s task of managing inflation is something like the tale of “Goldilocks and the Three Bears.” The Fed, working in tandem with the government’s fiscal policy, tries to raise or lower rates by just the right amount — not too high, not too low — to strike the right balance of employment opportunities and help stabilize prices.

In summary

Inflation is a natural economic phenomenon and mild inflation may even be a sign of a healthy economy. But when inflation gets out of control and prices start skyrocketing, governments and policymakers may step in to raise interest rates as a countermeasure. Raising rates may help slow spending by increasing the cost of borrowing, potentially reducing economic activity to slow inflation down. Raising rates may also encourage saving, as money in a savings or CD account earns more interest than in a low rate environment.

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