How do higher interest rates contribute to the fight against inflation?
The idea is that people will spend less if borrowing money or carrying a balance on a credit card costs more.
US Federal Reserve declared a 75-basis point interest rate hike in an effort to combat the high inflation that had beaten the global financial markets. Global central banks took all necessary aggressive measures to lower the continuously rising inflation that was obstructing market expansion. Reserve Bank of India recently announced a 50-basis point increase in its policy rate in response to the rising inflationary concerns and a decline in the value of the rupee.
Now the question is, how does raising interest rates help combat inflation?
The target interest rate is managed by the central bank. In order to control short-term interest rates as part of its monetary policy strategy, the central bank establishes a target interest rate.
To fund loans to individuals and companies, banks sometimes borrow money from one another. Therefore, when any central bank increases its target rate, it also increases the cost of borrowing for banks that need money to make loans or satisfy regulatory requirements.
Naturally, banks pass these higher costs to customers and companies. Accordingly, if the central bank increases the rate by 50 basis points, consumers and businesses will also pay more for borrowing money.
The idea is that people will spend less if borrowing money or carrying a balance on a credit card costs more. Spending will decrease, which will lead to a decrease in demand and eventually, in the cost of basic goods.
Interest rates and inflation are inversely related. Inflation typically rises when interest rates are low and declines at high-interest rates. Therefore, a contractionary policy that raises interest rates can be used to reduce inflation and return the economy to its price stability portion.