How does raising interest rates slow inflation?
September 7, 2022 7:40 AM Subscribe
So, Canada's central bank just raised interest rates a huge amount again, in order to fight inflation. But as someone who doesn't really understand the economic mechanisms of that, it seems to me like making money more expensive would just make everything more expensive. But that's obviously not the case, so what am I missing?
Like, okay, the housing market might cool so prices would drop, but if you're paying more money on your mortgage instead of for your house, how does that help?
And maybe people are borrowing less money to buy things, but then aren't companies paying more money to make things and shouldn't that drive up prices, too?
Happy for either explanations or links to good explanations.
Like, okay, the housing market might cool so prices would drop, but if you're paying more money on your mortgage instead of for your house, how does that help?
And maybe people are borrowing less money to buy things, but then aren't companies paying more money to make things and shouldn't that drive up prices, too?
Happy for either explanations or links to good explanations.
Borrowing money gets more expensive, so people borrow less money.
People who borrow less money have to reduce their consumption.
As demand goes down, so do - eventually - prices.
What will happen first however is that companies also reduce supply to match reduced demand, which means closing factories and shops and firing people.
Which means consumption will be reduced even more, because people have to cut spending when they're unemployed.
So bascially, raising interest rates to reduce inflation often works by causing a recession. But that's the pessimistic take.
Sometimes it's good to burst a bubble, as with the housing market.
posted by sohalt at 7:51 AM on September 7, 2022 [5 favorites]
People who borrow less money have to reduce their consumption.
As demand goes down, so do - eventually - prices.
What will happen first however is that companies also reduce supply to match reduced demand, which means closing factories and shops and firing people.
Which means consumption will be reduced even more, because people have to cut spending when they're unemployed.
So bascially, raising interest rates to reduce inflation often works by causing a recession. But that's the pessimistic take.
Sometimes it's good to burst a bubble, as with the housing market.
posted by sohalt at 7:51 AM on September 7, 2022 [5 favorites]
Economics is largely a pseudo-science and a lot of things the central banks do are for perception. That said if rates are higher, money is more expensive and in theory will slow inflation. I think what that means in reality is that large institutions will not borrow as much and in turn hire as much or pay as much. People and corporations will stop paying for things and then prices will, in theory, go down.
posted by geoff. at 7:54 AM on September 7, 2022 [5 favorites]
posted by geoff. at 7:54 AM on September 7, 2022 [5 favorites]
sohalt has the basics, with the caveat that the central banks are trying this time to dampen demand just enough to reduce inflation, but not so much that they cause a recession. The metaphors are "threading a needle" or getting to a "soft landing."
If you want the 5 minute read version, here's one from the IMF: Monetary Policy: Stabilizing Prices and Output.
posted by Mr.Know-it-some at 8:02 AM on September 7, 2022 [2 favorites]
If you want the 5 minute read version, here's one from the IMF: Monetary Policy: Stabilizing Prices and Output.
posted by Mr.Know-it-some at 8:02 AM on September 7, 2022 [2 favorites]
Economics is largely a pseudo-science and a lot of things the central banks do are for perception.
I agree that Economics is often more theology than science, but I would add that doing things for perception can be very important, especially when it comes to something like inflation. Because inflation is very much driven by perceptions - the more people fear it, the worse it gets. (If people expect prices to increase dramatically in the near future, they start panic-buying as much as they can while it's still affordable, thus driving up demand and prices even more).
Raising interests rates could be a good and a bad thing in that regard.
The central banks did not initially raise interest rates, when inflation increased. They argued that inflation was mostly caused by supply chain issues due to the pandemic, and would therefore be temporary, once that got resolved.
On the one hand, the fact that central banks have finally decided to raise interest rates, means they no longer believe inflation to be temporary. That drives home how dire the situation is becoming and might make some people worry about inflation more.
On the other hand, lots of people probably can't believe that inflation will be temporary at this point anyway, and would worry even more about if the central banks weren't taking steps. Even if inflation might not go down any time soon, it would be good if it at least didn't increase too much too fast any longer.
posted by sohalt at 8:16 AM on September 7, 2022 [1 favorite]
I agree that Economics is often more theology than science, but I would add that doing things for perception can be very important, especially when it comes to something like inflation. Because inflation is very much driven by perceptions - the more people fear it, the worse it gets. (If people expect prices to increase dramatically in the near future, they start panic-buying as much as they can while it's still affordable, thus driving up demand and prices even more).
Raising interests rates could be a good and a bad thing in that regard.
The central banks did not initially raise interest rates, when inflation increased. They argued that inflation was mostly caused by supply chain issues due to the pandemic, and would therefore be temporary, once that got resolved.
On the one hand, the fact that central banks have finally decided to raise interest rates, means they no longer believe inflation to be temporary. That drives home how dire the situation is becoming and might make some people worry about inflation more.
On the other hand, lots of people probably can't believe that inflation will be temporary at this point anyway, and would worry even more about if the central banks weren't taking steps. Even if inflation might not go down any time soon, it would be good if it at least didn't increase too much too fast any longer.
posted by sohalt at 8:16 AM on September 7, 2022 [1 favorite]
John Oliver covered this in depth last month, both the supply side of inflation that interest rates can affect and the demand side that they can’t. Sometimes there is too much money sloshing around when interest rates are low and that makes prices go up, other times there is not enough stuff available when the global economy has been hit by a pandemic and that also makes prices go up.
posted by migurski at 8:18 AM on September 7, 2022
posted by migurski at 8:18 AM on September 7, 2022
It might be helpful to consider the opposite situation. How do low interest rates cause inflation?
People often borrow money for large purchases: houses, cars, even furniture. When someone borrows money to make one of these purchases, they need to figure out how much they can afford to pay every month to repay the loan. When interest rates are higher, those monthly payments will be higher. When interest rates are lower, those monthly payments will be lower.
Lower monthly payments mean that more people can buy houses, cars, and furniture. People can also buy more expensive houses, cars, and furniture for the same monthly payment.
When more people want to buy things, the prices of those things often go up. This is true especially when the supply of those things are limited. If a company has 100 cars to sell and there are 150 people who want to buy them, the company is motivated to raise the price of the cars.
That's how low interest rates create inflation: they increase buying power, not just for big purchases but also for small purchases.
Increasing interest rates has the effect of reducing everyone's buying power. When people can't buy as much, they don't buy as much and prices tend to go down.
posted by Winnie the Proust at 8:21 AM on September 7, 2022 [3 favorites]
People often borrow money for large purchases: houses, cars, even furniture. When someone borrows money to make one of these purchases, they need to figure out how much they can afford to pay every month to repay the loan. When interest rates are higher, those monthly payments will be higher. When interest rates are lower, those monthly payments will be lower.
Lower monthly payments mean that more people can buy houses, cars, and furniture. People can also buy more expensive houses, cars, and furniture for the same monthly payment.
When more people want to buy things, the prices of those things often go up. This is true especially when the supply of those things are limited. If a company has 100 cars to sell and there are 150 people who want to buy them, the company is motivated to raise the price of the cars.
That's how low interest rates create inflation: they increase buying power, not just for big purchases but also for small purchases.
Increasing interest rates has the effect of reducing everyone's buying power. When people can't buy as much, they don't buy as much and prices tend to go down.
posted by Winnie the Proust at 8:21 AM on September 7, 2022 [3 favorites]
If inflation is high enough, and lasts for long enough, it starts to become expected by consumers. Then they will learn to just spend any excess cash they have immediately, rather than save it, because any money they keep in the bank will just lose value. This in turn will serve to keep perpetuating inflation, independent of any supply issues. Raising interest rates will encourage people to start saving money again.
posted by 1970s Antihero at 8:38 AM on September 7, 2022 [1 favorite]
posted by 1970s Antihero at 8:38 AM on September 7, 2022 [1 favorite]
Like, okay, the housing market might cool so prices would drop, but if you're paying more money on your mortgage instead of for your house, how does that help?
You pay more mortgage on your house, so you can't afford to go on vacation this year, have to cancel your Netflix-subscription, go eat out less often. That's going to reduce demand and prices for hotels, Air BnB, plane tickets, restourants, Netflix, etc.
And maybe people are borrowing less money to buy things, but then aren't companies paying more money to make things and shouldn't that drive up prices, too?
Companies are paying more money to make things because of the supply chain issues, the war in Ukraine, the rising energy costs, etc. and that's definitely driving up rices right now, argueably the main reason, why we are in this situation. And you are also right, that this part of the problem won't be solved by raising interest rates.
On the contrary, you're right that production costs might even increase, if companies don't generate enough cash-flow to fund these expenses and have to take out loans purely to stay operational, since these loans are getting now more expensive. But as I said, companies are likely to react by cutting costs, which most often translate to lay-offs. And lay-offs reduce aggregate demand even more, so it all works out in the end (if you are a bit patient and your only concern is reducing inflation.).
posted by sohalt at 8:40 AM on September 7, 2022 [1 favorite]
You pay more mortgage on your house, so you can't afford to go on vacation this year, have to cancel your Netflix-subscription, go eat out less often. That's going to reduce demand and prices for hotels, Air BnB, plane tickets, restourants, Netflix, etc.
And maybe people are borrowing less money to buy things, but then aren't companies paying more money to make things and shouldn't that drive up prices, too?
Companies are paying more money to make things because of the supply chain issues, the war in Ukraine, the rising energy costs, etc. and that's definitely driving up rices right now, argueably the main reason, why we are in this situation. And you are also right, that this part of the problem won't be solved by raising interest rates.
On the contrary, you're right that production costs might even increase, if companies don't generate enough cash-flow to fund these expenses and have to take out loans purely to stay operational, since these loans are getting now more expensive. But as I said, companies are likely to react by cutting costs, which most often translate to lay-offs. And lay-offs reduce aggregate demand even more, so it all works out in the end (if you are a bit patient and your only concern is reducing inflation.).
posted by sohalt at 8:40 AM on September 7, 2022 [1 favorite]
There's a lot of unintended perverse outcomes, that's true, but when a CB comes in and announces the change to the interest rate (general term) it's a good idea to figure out if this is specifically impacting the base lending rate (BLR) or overnight policy rate (OPR) etc. The examples and comments above relates to this because a CB leverage really is on the supply-side monetary supply so it's also worth looking at which sectors they're intending to turn the heat down or up. It doesn't actually follow in a straightforward manner that inflation on the consumer price side will follow in tandem or as soon as the announcement (anything that happens quickly in response is emotive and sentiment-driven) because prices are usually baked-in for the quarter at least.
posted by cendawanita at 8:41 AM on September 7, 2022 [3 favorites]
posted by cendawanita at 8:41 AM on September 7, 2022 [3 favorites]
Also CB and the MOF controls monetary policy but MOF at large along with your equivalent strategic ministries are the ones that dictate the fiscal policy. They should go hand in hand, in basic economics anyway. So fiddling with the tap of the monetary supply doesn't have to result in overall inflation on the consumer end, because that should be addressed through overall fiscal strategy can redirect resources in response to constricted money in the system (welfare, subsidies, quotas, targeted assistance, such like things).
posted by cendawanita at 8:47 AM on September 7, 2022 [2 favorites]
posted by cendawanita at 8:47 AM on September 7, 2022 [2 favorites]
So fiddling with the tap of the monetary supply doesn't have to result in overall inflation on the consumer end, because that should be addressed through overall fiscal strategy can redirect resources in response to constricted money in the system (welfare, subsidies, quotas, targeted assistance, such like things).
Hard agree. My impression is that monetarism and fiscalism are sometimes presented in opposition to each other, just because some proponents of monetarism have historically had some ideological problems with taxes and debt. But my dream policy would also consiste of a combination of both - raise interest rates somewhat, sure, to cut down on stuff like asset price inflation for instance, and soften the blow for the poor through an increase in government spending, through welfare, subsidies, loan forgiveness etc.
It's a policy mix that is very difficult to pull off, though: Increase in government spending is politically hard to implement in times of inflation, because it also increases inflation. Unless its funded by an increase in taxes (also very difficult to implement politically), it will also increase budget deficts and debts. National debt however becomes a much more serious concern, once interest rates are rising.
So far, most national economies (the US and the EU for sure) have handled the most recent crises caused by the pandemic with an increase of government spending (subsidies for companies though mostly, not so much welfare) and national debt. This has worked, because interest rates were very low. One reason why the central banks have hesitated to raise interest rates for so long, and are now doing so still fairly incrementally, is that many countries have so much debt, raising interest rates too quickly might drive them into bankruptcy. In such a situation, it's very tricky to get buy-in for an increase of government debt. (Which is why I'm personally more for raising taxes. That's also bound to decrease demand, if we have to have an economic downturn anway, why not one caused by taxes?)
Point is, I deeply believe we have to figure out a way to handle economic downturns in a way that spreads the pain more fairly, regardless of the current problem with inflation. Because the current system relying on increasing debt enabled by permanent economic growth won't be sustainable not just for inflationary but also for ecological reasons.
posted by sohalt at 9:17 AM on September 7, 2022 [4 favorites]
Hard agree. My impression is that monetarism and fiscalism are sometimes presented in opposition to each other, just because some proponents of monetarism have historically had some ideological problems with taxes and debt. But my dream policy would also consiste of a combination of both - raise interest rates somewhat, sure, to cut down on stuff like asset price inflation for instance, and soften the blow for the poor through an increase in government spending, through welfare, subsidies, loan forgiveness etc.
It's a policy mix that is very difficult to pull off, though: Increase in government spending is politically hard to implement in times of inflation, because it also increases inflation. Unless its funded by an increase in taxes (also very difficult to implement politically), it will also increase budget deficts and debts. National debt however becomes a much more serious concern, once interest rates are rising.
So far, most national economies (the US and the EU for sure) have handled the most recent crises caused by the pandemic with an increase of government spending (subsidies for companies though mostly, not so much welfare) and national debt. This has worked, because interest rates were very low. One reason why the central banks have hesitated to raise interest rates for so long, and are now doing so still fairly incrementally, is that many countries have so much debt, raising interest rates too quickly might drive them into bankruptcy. In such a situation, it's very tricky to get buy-in for an increase of government debt. (Which is why I'm personally more for raising taxes. That's also bound to decrease demand, if we have to have an economic downturn anway, why not one caused by taxes?)
Point is, I deeply believe we have to figure out a way to handle economic downturns in a way that spreads the pain more fairly, regardless of the current problem with inflation. Because the current system relying on increasing debt enabled by permanent economic growth won't be sustainable not just for inflationary but also for ecological reasons.
posted by sohalt at 9:17 AM on September 7, 2022 [4 favorites]
They are trying to avoid what is called an inflationary spiral. If prices go up, then wages go up to match them, then prices will continue to rise, then wages will continue to rise, and so on.
The prices have already risen, but wages have largely not risen (generally, they are much slower to change because changing jobs, getting a raise or negotiating a cost of living increase takes a lot longer than buying groceries). So they figure they can slow the economy in general by making borrowing more expensive, most importantly for businesses, increasing unemployment, reducing the demand for labour while keeping the supply constant thus avoiding an increase in wages.
The theory is that if wages don't increase, prices won't increase any more. So working people take an effective pay cut (because their dollars buy less due to inflation) and that's the end of it, in theory.
There's no doubt that a lot of inflation is generally not great, but it's a lot less clear that the best way to handle this is basically to shaft working people. Of course, if you think long term, what happens when this pattern is repeated is not great (real wages stagnate, the rich get richer in relative terms, increasing inequality — which sounds a lot like the last half century or more of economic history).
That's not the only effect and, as others have pointed out here, perception is often more important than reality, but that's a major one. In general, macroeconomics is poorly understood and there are multiple theories about how things actually work, so there is no definitive answer.
posted by ssg at 9:27 AM on September 7, 2022 [3 favorites]
The prices have already risen, but wages have largely not risen (generally, they are much slower to change because changing jobs, getting a raise or negotiating a cost of living increase takes a lot longer than buying groceries). So they figure they can slow the economy in general by making borrowing more expensive, most importantly for businesses, increasing unemployment, reducing the demand for labour while keeping the supply constant thus avoiding an increase in wages.
The theory is that if wages don't increase, prices won't increase any more. So working people take an effective pay cut (because their dollars buy less due to inflation) and that's the end of it, in theory.
There's no doubt that a lot of inflation is generally not great, but it's a lot less clear that the best way to handle this is basically to shaft working people. Of course, if you think long term, what happens when this pattern is repeated is not great (real wages stagnate, the rich get richer in relative terms, increasing inequality — which sounds a lot like the last half century or more of economic history).
That's not the only effect and, as others have pointed out here, perception is often more important than reality, but that's a major one. In general, macroeconomics is poorly understood and there are multiple theories about how things actually work, so there is no definitive answer.
posted by ssg at 9:27 AM on September 7, 2022 [3 favorites]
Unless its funded by an increase in taxes (also very difficult to implement politically), it will also increase budget deficts and debts. National debt however becomes a much more serious concern, once interest rates are rising.
The budget deficit is actually falling so I find complaints about 'loose monetary policy' pretty weak, so everyone that wants higher interest rates is also tacitly ok with increasing budget deficits, short of seriously shrinking the size of the government.
Also, sure, at a national level, increases in lending are difficult to offset in extra taxes due to politics, but at the local level, increasing home prices are most assuredly leading to rising taxes, so that line of thinking is weak too.
Surprise, surprise - people's interest in taxes is an abstraction vs their own net worth increasing and their desire to segregate themselves economically. So increasing inflation is also a real abstraction, and 'fighting it' is dumb. Some people do need help - that help should be directed. But most people aren't actually negatively effected, so Central Bank efforts to tame inflation are more about maintaining the purchasing power of the upper middle class at the expense of the lower income classes.
posted by The_Vegetables at 9:30 AM on September 7, 2022 [1 favorite]
The budget deficit is actually falling so I find complaints about 'loose monetary policy' pretty weak, so everyone that wants higher interest rates is also tacitly ok with increasing budget deficits, short of seriously shrinking the size of the government.
Also, sure, at a national level, increases in lending are difficult to offset in extra taxes due to politics, but at the local level, increasing home prices are most assuredly leading to rising taxes, so that line of thinking is weak too.
Surprise, surprise - people's interest in taxes is an abstraction vs their own net worth increasing and their desire to segregate themselves economically. So increasing inflation is also a real abstraction, and 'fighting it' is dumb. Some people do need help - that help should be directed. But most people aren't actually negatively effected, so Central Bank efforts to tame inflation are more about maintaining the purchasing power of the upper middle class at the expense of the lower income classes.
posted by The_Vegetables at 9:30 AM on September 7, 2022 [1 favorite]
The budget deficit is actually falling so I find complaints about 'loose monetary policy' pretty weak, so everyone that wants higher interest rates is also tacitly ok with increasing budget deficits, short of seriously shrinking the size of the government.
Budget deficits can fall inspite of increased government spending without a corresponding increase in taxes, if there is sufficient economic growth/increase in GDP, because of the multiplier effect of government spending. This has indeed worked out for a bit for a while. I'm not sure it can work forever (see ecological constraints, doubts about the possibility of Green Growth, etc) but personally, I would probably try rely on that strategy for a bit longer too right now.
Also, sure, at a national level, increases in lending are difficult to offset in extra taxes due to politics, but at the local level, increasing home prices are most assuredly leading to rising taxes, so that line of thinking is weak too.Surprise, surprise - people's interest in taxes is an abstraction vs their own net worth increasing and their desire to segregate themselves economically.
Yeah, I suspect lots of people who are categorically against raising taxes are mostly against redistribution. Even if their own material circumstance might not seriously be affected by higher taxes (or might even be improved, through improved infrastructure and well-tended commons), they oppose them, because it might lessen the social distance between them and those they want to feel superior to. This phenomenon is even heightened by racism. Sad truth is, people can be fairly content with very little, as long as they have more than their neighbour, which is why just appealing to rational self-interest in politics is not always as successful as one might hope.
So increasing inflation is also a real abstraction, and 'fighting it' is dumb. Some people do need help - that help should be directed. But most people aren't actually negatively effected, so Central Bank efforts to tame inflation are more about maintaining the purchasing power of the upper middle class at the expense of the lower income classes.
I do think inflation can get out of control and worries about that are legitimate. I went to Istanbul in August for a wedding. They had something like 80% (official figure) to 170% (other reports I read) inflation. Seemed to me like most people were indeed quite negatively effected. I asked a friend who went there three years ago about his impression of the homeless situation - he said it hadn't seemed to him much worse than in Vienna. When I went there in August, there were people sleeping in doorways everywhere, street musicians aged 5 to 10, teenagers working as freelance waste collectors, a little boy, sleeping on a cardboard on the Galata bridge, a young mother, searching the garbage can for something to feed her toddler.
I don't know what they did in Turkey to have it go that badly, but one thing they certainly didn't do is raise interest rates. In fact, they've just cut them again. We'll see how that works out for them.
posted by sohalt at 10:01 AM on September 7, 2022 [1 favorite]
Budget deficits can fall inspite of increased government spending without a corresponding increase in taxes, if there is sufficient economic growth/increase in GDP, because of the multiplier effect of government spending. This has indeed worked out for a bit for a while. I'm not sure it can work forever (see ecological constraints, doubts about the possibility of Green Growth, etc) but personally, I would probably try rely on that strategy for a bit longer too right now.
Also, sure, at a national level, increases in lending are difficult to offset in extra taxes due to politics, but at the local level, increasing home prices are most assuredly leading to rising taxes, so that line of thinking is weak too.Surprise, surprise - people's interest in taxes is an abstraction vs their own net worth increasing and their desire to segregate themselves economically.
Yeah, I suspect lots of people who are categorically against raising taxes are mostly against redistribution. Even if their own material circumstance might not seriously be affected by higher taxes (or might even be improved, through improved infrastructure and well-tended commons), they oppose them, because it might lessen the social distance between them and those they want to feel superior to. This phenomenon is even heightened by racism. Sad truth is, people can be fairly content with very little, as long as they have more than their neighbour, which is why just appealing to rational self-interest in politics is not always as successful as one might hope.
So increasing inflation is also a real abstraction, and 'fighting it' is dumb. Some people do need help - that help should be directed. But most people aren't actually negatively effected, so Central Bank efforts to tame inflation are more about maintaining the purchasing power of the upper middle class at the expense of the lower income classes.
I do think inflation can get out of control and worries about that are legitimate. I went to Istanbul in August for a wedding. They had something like 80% (official figure) to 170% (other reports I read) inflation. Seemed to me like most people were indeed quite negatively effected. I asked a friend who went there three years ago about his impression of the homeless situation - he said it hadn't seemed to him much worse than in Vienna. When I went there in August, there were people sleeping in doorways everywhere, street musicians aged 5 to 10, teenagers working as freelance waste collectors, a little boy, sleeping on a cardboard on the Galata bridge, a young mother, searching the garbage can for something to feed her toddler.
I don't know what they did in Turkey to have it go that badly, but one thing they certainly didn't do is raise interest rates. In fact, they've just cut them again. We'll see how that works out for them.
posted by sohalt at 10:01 AM on September 7, 2022 [1 favorite]
The Bank of Canada has a series of short explainers on monetary policy, including one on its policy interest rate and one on its inflation target.
Its role and/or effectiveness in countering inflation and the impact average folks aside, 3.25 per cent (where it is now after the 75 basis point hike the BoC just announced) is not, historically speaking, extremely high (see the BoC bank rate from 1990 through 2022...the early 1990s were wild), given that we're coming off of an overnight rate that was almost zero (it was 0.25 per cent at the end of December 2021, for example).
But this is the highest the interest rates set by the BoC have been since both the U.S. Fed and the BoC initiated quantitative easing in 2008. What's happening now is basically the opposite of that.
posted by mandolin conspiracy at 10:04 AM on September 7, 2022 [2 favorites]
Its role and/or effectiveness in countering inflation and the impact average folks aside, 3.25 per cent (where it is now after the 75 basis point hike the BoC just announced) is not, historically speaking, extremely high (see the BoC bank rate from 1990 through 2022...the early 1990s were wild), given that we're coming off of an overnight rate that was almost zero (it was 0.25 per cent at the end of December 2021, for example).
But this is the highest the interest rates set by the BoC have been since both the U.S. Fed and the BoC initiated quantitative easing in 2008. What's happening now is basically the opposite of that.
posted by mandolin conspiracy at 10:04 AM on September 7, 2022 [2 favorites]
...it seems to me like making money more expensive would just make everything more expensive. But that's obviously not the case, so what am I missing?
You have the value of money flipped around. "Making money more expensive" is to say that you need to trade more goods & services than before to get the same amount of money. Making money more expensive is to make cheaper everything that you would buy with money.
If the value of 1 donut is 2 dollars, then a dollar is cheaper than a donut.
If the value of 2 donuts is 1 dollar, then a donut is cheaper than a dollar. The dollar is more expensive than in the previous scenario.
Note that the central bank won't actually try to make money more expensive. That would be deflation, and nobody wants that. Rather, the high rate of inflation means that money is getting cheaper too fast. The central bank wants to bring inflation back down to a low rate. Money will still be getting cheaper over time, just more slowly.
posted by polecat at 11:07 AM on September 7, 2022
You have the value of money flipped around. "Making money more expensive" is to say that you need to trade more goods & services than before to get the same amount of money. Making money more expensive is to make cheaper everything that you would buy with money.
If the value of 1 donut is 2 dollars, then a dollar is cheaper than a donut.
If the value of 2 donuts is 1 dollar, then a donut is cheaper than a dollar. The dollar is more expensive than in the previous scenario.
Note that the central bank won't actually try to make money more expensive. That would be deflation, and nobody wants that. Rather, the high rate of inflation means that money is getting cheaper too fast. The central bank wants to bring inflation back down to a low rate. Money will still be getting cheaper over time, just more slowly.
posted by polecat at 11:07 AM on September 7, 2022
If you already have an appetite for podcast like things, this week was this year's Global Policy Forum organized by the Alliance for Financial Inclusion (disclaimer: I'm connected in the sector). Its membership are financial regulators from 'global South' countries so they're not heterodox BUT since the central bankers in this network are committed to some pretty high-minded development goals you can guess they're not just that strict monetarist school either. This is the closing ceremony livestream, just skip ahead to the 4th hour (around 4:15:xx) for the closing plenary session which is on contemporary financial regulation. There's a bit of a historical recap on where the field is and it might be interesting to hear non-western views on how central banks should work on society. It doesn't answer your initial question directly but I thought it might be of interest for you to get a sense of the in-field discourse, especially as the comments are beginning to expand into that anyway.
posted by cendawanita at 8:25 AM on September 8, 2022 [1 favorite]
posted by cendawanita at 8:25 AM on September 8, 2022 [1 favorite]
One way to look at this: first, imagine overnight money doubled everywhere it exists (bank accounts, loans, etc). Since in theory nothing REAL has changed, you'd expect the price of everything else (products, wages, stocks, etc.) would also double to reflect the fact that everyone has twice the number of dollars in their accounts. This is a basic illustration of how the supply of money affects prices.
Now, the vast majority of "money" is created by loans from banks - it's not determined by some stable quantity of government-issued currency. In general, the quantity of loans banks issue is determined by supply and demand. When money is "cheap" (ie, when interest rates are low), people and businesses take out more loans and the supply of money in the economy increases, and when money is "expensive" (when interest rates are high), people and businesses take out fewer loans and the supply of money shrinks. When the Fed raises interest rates, banks have a more profitable risk-free alternative to issuing loans, so they raise the interest rate they charge on mortgages and business loans and lines of credit and such. People borrow less, and the amount of money in an economy declines. Since the supply of money affects how much prices increase or decrease (in a vacuum), interest rates directly affect inflation.
posted by exutima at 6:43 PM on September 8, 2022
Now, the vast majority of "money" is created by loans from banks - it's not determined by some stable quantity of government-issued currency. In general, the quantity of loans banks issue is determined by supply and demand. When money is "cheap" (ie, when interest rates are low), people and businesses take out more loans and the supply of money in the economy increases, and when money is "expensive" (when interest rates are high), people and businesses take out fewer loans and the supply of money shrinks. When the Fed raises interest rates, banks have a more profitable risk-free alternative to issuing loans, so they raise the interest rate they charge on mortgages and business loans and lines of credit and such. People borrow less, and the amount of money in an economy declines. Since the supply of money affects how much prices increase or decrease (in a vacuum), interest rates directly affect inflation.
posted by exutima at 6:43 PM on September 8, 2022
There was an interesting explainer on Vox today that goes over how raising the interest rates tends to affect inflation, why this has become the de-facto solution to inflation in our economy, and what the disadvantages of this approach are.
posted by flug at 9:28 PM on September 8, 2022
posted by flug at 9:28 PM on September 8, 2022
The Intercept has a better article, about why raising rates is a bad idea from The Fed's own economists, in contrast to their public comments:
The Intercept - Fed Economist Warns of Severe Recession from Fed's Rate Hikes
The Study mentioned in the article
posted by The_Vegetables at 11:12 AM on September 9, 2022
The Intercept - Fed Economist Warns of Severe Recession from Fed's Rate Hikes
The Study mentioned in the article
posted by The_Vegetables at 11:12 AM on September 9, 2022
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To use housing as an example: If interest rates are low, there's more incentive to take out loans and 'flip' houses, thereby increasing demand (everyone buying a house to live in is now competing against someone looking to buy and resell it) and prices (people buying houses to flip need a return on their investment, so the price is higher)
Raising interest rates is one way to maybe take the speculation out of the economy by providing a disincentive. Now the cost of the loan needed to buy the house isn't worth the return one would make by quickly fixing it up and reselling it.
posted by RonButNotStupid at 7:50 AM on September 7, 2022 [1 favorite]