How do interest rates affect inflation?

Central banks do a lot behind the scenes to steer an economy in a desired direction, from responding to domestic shocks, ensuring the right number of people have employment and — perhaps most importantly — keeping inflation within a healthy range.

Inflation is the increase in the price of goods and services, which translates to a reduction in the purchasing power of consumers and businesses over time. Put simply, inflation means your dollar buys you less now than it did before.

In Australia, the most common measure of inflation is the Consumer Price Index (CPI). This collects the prices for thousands of items and weights them according to how much space they take up in households’ budgets. 

Each quarter, the Australian Bureau of Statistics (ABS) works out how much more expensive those items are compared to the previous quarter and aggregates them to give us the current rate of inflation.

The official interest rate (also known as the cash rate or policy rate) is an important tool central banks use to manage the flow of credit in an economy.

Technically, it reflects the cost of overnight loans, which are the funds banks lend to each other in wholesale money markets to cover their daily cash needs.

When you sign up for a home loan, your bank will borrow from money markets to fund it. The rate you’re charged is largely based on the cash rate, though banks will mark up the price to ensure a profit is made.

Where interest rates sit influences how much debt households and businesses are willing to take on. This in turn affects spending, unemployment and, as we’ll see below, inflation.

• Incentivises saving
  

• Discourages spending, borrowing and investing
  

• Decreases demand
  

When a central bank increases interest rates, it raises the cost of borrowing for commercial banks. Naturally, banks pass this onto customers by pushing up rates on home and business loans.

At the same time, the amount they can afford to pay out to savers also goes up, meaning you’ll get much more attractive returns on the money you have in your savings account.

By (1) making it harder for households and businesses to obtain credit and (2) encouraging people to keep their money idle in the bank, a central bank is able to reduce demand and slow economic activity.

Wanting to hamper economic activity might seem counterintuitive, but central banks see it as their duty to intervene when there’s too much demand relative to production and it’s pushing up the cost of goods.

So how does it work? As mortgage costs go up, households on fixed budgets will inevitably cut back on spending. While this might not necessarily cause prices to fall, it can slow the rate of inflation to a pace that’s more manageable.

Price stability can also be achieved by deterring businesses from buying more equipment and hiring new staff, both typically financed through debt. This eats into profits and ultimately leads to higher unemployment, slower wage growth and reduced spending.

• Discourages saving
  

• Incentivises spending, borrowing and investing
  

• Increases demand
  

If the economy is underperforming or it’s in the midst of a downturn, a central bank can intervene by lowering interest rates. This shifts the economic mood in ways that are believed to stimulate demand.

For example, as the cost of borrowing decreases, more people with sights on the property market are encouraged to get off the sidelines and buy a home. 

The resulting competition drives up housing prices and adds to existing property owners’ wealth, at least on paper. This newfound wealth then fuels spending elsewhere in the economy.

A similar dynamic plays out in the share market. If savings account rates are offering negligible returns, people looking to make their money work for them will turn elsewhere. For many, share trading emerges as an attractive alternative.

As more money is pumped into the share market, the value of investors’ portfolios increases. They then experience the same wealth effect that made property owners more comfortable loosening their purse strings.

All this consumer confidence is good news for businesses, who can use the profits to hire more workers and pay more generous wages. They can also take advantage of cheap finance to expand in other ways, such as by investing in technologies that increase competitiveness.

Most central banks set an inflation target. For example, the Reserve Bank of Australia prefers inflation to stay within 2-3% each year, while other central banks, such as the US Federal Reserve, the Bank of England and the European Central Bank, follow a 2% inflation target.

But why is inflation desirable in the first place? Wouldn’t it be preferable if the price of goods and services wasn’t constantly rising?

Not necessarily. The way central banks see it, a little bit of inflation is needed to drive consumer demand. By instilling the belief that prices will go up in the future, central banks can induce people to spend now. 

RELATED: Cost of living in 2022

A low and predictable rate of inflation is preferable to deflation, which is when prices are falling. In a deflationary environment, people will put off buying big-ticket items like cars, houses, and appliances in the hopes of getting a better deal in the future.

This can cause prices to spiral even further down, as happened during the 2008 housing collapse in the US. At the time, the bottom fell out of the property market as no one wanted to spend money on something they knew would only drop in value.

For more information about central banks and the tools they have at their disposal, read our guide to monetary policy.