How do interest rate hikes combat inflation?

The Bank of Canada is shown in Ottawa on Tuesday, July 12, 2022. Bank of Canada deputy governor Paul Beaudry says in hindsight, governments and central banks should have withdrawn stimulus measures earlier as economies recovered from the COVID-19 pandemic, which likely would have kept a lid on inflation. THE CANADIAN PRESS/Sean Kilpatrick

As Canadians weather inflation amidst economic uncertainty, many are asking a fundamental question about the Bank of Canada’s policy strategy: how do increased interest rates tame inflation?

The answer comes down to spending behaviour.

“Higher interest rates encourage saving and discourage borrowing and, in turn, spending,” the Bank of Canada (BoC) explains on its website. “In response, companies increase their prices more slowly or even lower them to encourage demand.”

In order to achieve the inflation target, the BoC will adjust the policy rate, prompting banks to increase interest rates on their deposits, loans and mortgages, and initiating a chain reaction in the exchange of goods and services.

In an effort to measure inflation each month, Statistics Canada tracks the prices of consumer goods and services, all contributing to what’s called “the consumer price index” (CPI). This measurement represents “big picture” spending across Canada, and the data is commonly considered by businesses, institutions and governments to understand financial trajectories.

Expectation is a key component of inflation troubles.

“If people expect that prices will rise, on average, by about 2 per cent each year, employers and workers are more likely to agree to a 2 per cent wage increase to compensate for the higher cost of living,” the Bank of Canada said. “And since wages affect the cost of producing goods and services, and the cost affects their prices, this cycle helps the Bank keep inflation on target.”

Simply put, if the cost of goods outweigh people’s income, people will buy less and the economy will slow. General purchasing power will decrease throughout the economy.

“High inflation can mean that people who have saved for their retirement may find themselves with less money than they expected,” says the BoC. “Businesses and consumers must spend time and effort trying to protect themselves from the effects of rising costs.”

But as bad as high inflation is, deflation — where prices plummet – isn’t much better.

“A drop in some prices can boost demand for those items,” says the BoC. “But a general, persistent fall in prices is usually a symptom of deep problems in an economy.”

Because of this, the BoC also leverages interest rates when it comes to enabling more spending.

“Lower interest rates work in the opposite way and can help increase inflation if it is too low.”

It all comes down to purchasing power – and the fuel behind it, the BoC explains. When people lose their jobs, they have less money to spend. As a result of this, when a business is experiencing fewer sales, they may drop their prices – but that’s a result of lowered demand.

“As more money is saved, less money is spent, prices fall further, and economic activity shrinks.”