How Does Raising Interest Rates Help Inflation? | Chase (2024)

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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How Does Raising Interest Rates Help Inflation? | Chase (2024)

FAQs

How Does Raising Interest Rates Help Inflation? | Chase? ›

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.

How does putting up interest rates help inflation? ›

Higher interest rates help to slow down price rises (inflation). That's because they reduce how much is spent across the UK. Experience tells us that when overall spending is lower, prices stop rising so quickly and inflation slows down.

Who benefits from higher interest rates? ›

As interest rates rise, the interest income from loans typically increases faster than the interest paid on deposits, leading to wider profit margins. Additionally, higher interest rates can boost the earnings of insurance companies and investment firms, as they often hold large portfolios of interest-sensitive assets.

What are the solutions to inflation? ›

Monetary policy primarily involves changing interest rates to control inflation. Governments through fiscal policy, however, can assist in fighting inflation. Governments can reduce spending and increase taxes as a way to help reduce inflation.

What happens when the Fed raises interest rates? ›

When the Fed increases the federal funds rate, it typically pushes interest rates higher overall, which makes it more expensive for businesses and individuals to borrow. The higher rates also promote saving.

Why is inflation so high? ›

As the labor market tightened during 2021 and 2022, core inflation rose as the ratio of job vacancies to unemployment increased. This ratio is used to measure wage pressures that then pass through to the prices for goods and services.

What causes inflation to rise? ›

If the money supply grows too big relative to the size of an economy, the unit value of the currency diminishes; in other words, its purchasing power falls and prices rise.

Is the Fed raising interest rates a good thing? ›

Higher rates can be a good sign

There is little precedent for the Fed to cut rates in robust growth periods such as the present, with gross domestic product expected to accelerate at a 2.4% annualized pace in the first quarter of 2024, which would mark the seventh consecutive quarter of growth better than 2%.

Who gets hurt by higher interest rates? ›

“Having interest rates higher for a longer period of time is going to hurt people who have a lot of credit card debt,” Taylor said. In similar fashion, mortgage rates are likely to remain costly, posing difficulty for prospective homebuyers who've faced elevated loan costs for two years.

Why do banks make more money when interest rates rise? ›

When interest rates are higher, banks make more money by taking advantage of the greater spread between the interest they pay to their customers and the profits they earn by investing. A bank can earn a full percentage point more than it pays in interest simply by lending out the money at short-term interest rates.

How to fight inflation without raising interest rates? ›

  1. Increase wealth taxes. ...
  2. Impose a windfall profits tax. ...
  3. End the affordable-housing crisis. ...
  4. Reduce our dependency on oil. ...
  5. Give workers the pay they need to keep up. ...
  6. Invest in immigration, childcare and seniors' care. ...
  7. Help low-income families.

Can the president control inflation? ›

A president's actions in office—such as tax cuts, wars, and government aid—can affect prices and the economy overall. The president plays a significant role in deciding how to respond to high inflation or stimulate the economy during a slowdown.

Why are interest rates so high? ›

When the Prime Rate is high, borrowing money is more expensive. This causes increased interest rates and lower spending. This also effectively lowers inflation. This is why the Federal Reserve raised interest rates in 2022, to fight rising inflation.

Why won't raising interest rates work? ›

Raising borrowing costs for consumers theoretically means they have less to spend on other goods and services. Just as importantly, it raises borrowing costs for businesses, reducing demand for investment and lowering profits. This lowers their ability to employ people or give inflation-busting pay rises.

Why are high interest rates bad for banks? ›

Besides loans, banks also invest in bonds and other debt securities, which lose value when interest rates rise. Banks may be forced to sell these at a loss if faced with sudden deposit withdrawals or other funding pressures.

Do banks make more money when interest rates rise? ›

A rise in interest rates automatically boosts a bank's earnings. It increases the amount of money that the bank earns by lending out its cash on hand at short-term interest rates.

Does increasing interest rates strengthen currency? ›

Generally, higher interest rates increase the value of a country's currency. Higher interest rates tend to attract foreign investment, increasing the demand for and value of the home country's currency.

Does raising interest rates lower unemployment? ›

Does Raising Interest Rates Increase Unemployment? It can have that effect. By raising the bar for investment, higher interest rates may discourage the hiring associated with business expansion. They also cap employment by restraining growth in consumption.

Why should a rise in the price level but not in expected inflation cause interest rates to rise when the nominal money supply is fixed? ›

When a result of this, people wish to keep their money as the price level rises. As a result, the demand curve for money will shift to the right in this situation. The interest rate rises as you move to the right. As a result of the decrease in money's purchasing power, interest rates will rise.

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