Will someone please explain how raising interest rates controls inflation.
Is it supposed to stop people from spending?
If a seller borrows money aren’t they going to pass along the rise in money costs to the consumer?
Isn’t that inflation?
The simple explanation is: higher interest rates provide incentive for consumers to save more money, thus spending less.
Isn’t consumer spending what drives the economy? So if you cut spending don’t you perhaps stop growth?
Yes, which is why the Fed is acting “at a pace which is likely to be measured” while inflation hawks are screaming for faster increases. Essentially, the Fed is saying that they want to increase rates slowly so as to tame inflation without stopping growth. The hawks are saying that a faster rate is required to do that.
To your direct question: An increase in interest rates influence demand-pull inflation precisely by slowing growth – specifically, growth in demand which is in excess of an economy’s ability to supply it. There are three major ways in which it decreases demand. Most obviously, a rate increase makes it more expensive for consumers to incur debt for purchases – whether it’s a car, a house or on the credit card. This has the double effect of reducing aggregate demand and shifting some planned expenses from the item itself to finance charges, causing consumers to seek better bargains from producers. Next, it (usually) increases savings, as the opportunity cost of consumption increases. Finally, it raises the rate of return hurdle for business investment, slowing demand in that area. This gets tricky, as one can easily see that decreasing business investment reduces the growth in capacity which would allow an economy to grow its way out of an inflationary pickle. All I can say is that past attempts to look at inflation that way were disasters.
However, there’s another kind of inflation – cost-push inflation. This is where input costs increase enough to squeeze out high-cost producers at the current price levels. If this is endemic enough, it could either result in inflation directly or indirectly by reducing capacity (depending on demand). The level of rates has relatively little effect on this kind of inflation. And that’s what the Fed is currently hanging its hat on – basically, they’re saying that at least some of the inflation we’re starting to see is cost-push, that rates won’t cure it and that, in the Fed’s words, “a portion of the increase in recent months appears to have been due to transitory factors.”
Not confused enough yet? Inflation (or the worry about it) also causes interest rates to increase. If a lender believes that inflation is going to be a problem, he believes that the money he receives back from a loan will be worth less than when he lended it. He will demand compensation for the decrease in the value of his dollar in the form of higher interest rates. This is why the yield curve is usually sloped positively – less is known about future inflation than about now inflation, so lenders demand to be compensated for the uncertainty of providing a 10-year loan instead of a 1-year loan or a resettable one.