How Interest Rates Reduce Inflation
Higher interest rates fight inflation by raising the real (inflation-adjusted) cost of borrowing, which cools spending and hiring and pulls demand back below the economy’s capacity, so price growth slows, with a lag of several quarters and a temporary cost in jobs.
The interest rate is the central bank's main lever against inflation. The chain of cause and effect runs like this:
The transmission chain
- The bank raises the policy rate.
- Borrowing (mortgages, business loans) gets more expensive, so households and firms spend and invest less.
- Weaker demand opens up slack: output falls below capacity and unemployment rises.
- Through the Phillips curve, that slack pulls inflation down, with a lag of several quarters.
Why it must be the real rate
What matters is the real rate (the nominal rate minus expected inflation). At 8% inflation, a 5% nominal rate is still deeply negative in real terms and does nothing. To actually bite, the rate has to get above the inflation rate, which is the Taylor Principle and the hard lesson of the Volcker years.
The cost
Disinflation through rates has a real price: the recession and the jobs lost on the way down. That cost is temporary (unemployment returns to its natural rate) and is smaller when credibility is high. There is no costless way to wring out entrenched inflation.