By country, interest rate hikes vs. inflation rate
Think of high inflation today as a car going fast down a hill. You have to hit the brakes to slow it down. In this case, the “brakes” are higher interest rates, which are meant to make people spend less. But some central banks are pulling back more quickly than others.
How does a rise in interest rates fight inflation?
We need to know how inflation works in order to understand how interest rates affect it. Inflation happens when too many people spend too much money on too few goods. In the last few months, this has happened because of a rise in demand and problems in the supply chain that have been made worse by Russia’s invasion of Ukraine.
Central banks will raise their policy rate to try to stop inflation. This is the rate they charge or pay commercial banks for loans or deposits. Some of these higher rates are passed on to customers by commercial banks. This makes it harder for businesses and consumers to buy things. For example, the cost of borrowing money for a house or car goes up.
In the end, when interest rates go up, they make people spend less and save more. This makes businesses want to raise prices more slowly or lower prices to boost demand.
Rates of interest going up and prices going up
Some countries’ inflation rates are at their highest levels in decades, so many central banks have said that they will raise interest rates. Below, we show how some countries and regions’ inflation rates and policy interest rates have changed since January 2022. The places are listed from highest inflation rate to lowest inflation rate.
When it comes to raising interest rates, the U.S. Federal Reserve has been the most aggressive. Since January, it has raised its policy rate by 1.5 percent, with half of that increase happening in June 2022. Jerome Powell, who is in charge of the Federal Reserve, said that the committee would like to “do a little more front-end loading” to get policy rates back to normal levels. The move comes at a time when the U.S. has its highest rate of inflation in 40 years.
On the other hand, inflation in the European Union is at 8.1%, but the policy rate has not been raised yet. But the European Central Bank has given clear direction for the future. It plans to raise rates by 0.25 percent in July, possibly by a larger amount in September, and then keep raising them slowly but steadily after that. Clear information about the future is meant to help people decide how to spend and invest their money and avoid surprises that could upset markets.
How to raise interest rates
Increasing interest rates is a tricky act of balancing. If central banks raise rates too quickly, it’s like slamming the brakes on that car speeding downhill: the economy could stop. In the 1980s, this happened in the United States when Federal Reserve Chair Paul Volcker raised the policy rate to 20%. The economy went into a recession, but the aggressive monetary policy did bring double-digit inflation under control in the end.
But if rates are raised too slowly, inflation could get so big that it would be hard to stop. The longer prices stay high, the more people expect inflation in the future. This can make people buy more because they expect prices to go up even more, which keeps demand high.
It’s important to remember that policy rates are only one part of the equation. Central banks can also affect demand in other ways. Inflation is also caused by problems in the supply chain, which are mostly out of the hands of central banks.
