How Higher Interest Rates Combat Inflation: Impact on Economy and Individuals

In the fight against inflation, central banks like the ECB use higher interest rates as their primary weapon. By increasing borrowing costs, consumer spending decreases, and demand in the economy falls, resulting in less money and easing inflation. However, this time around, inflation was caused by higher energy prices and supply chain problems, not consumer spending, making it harder for central banks to target the issue directly. Despite this, the ECB remains committed to its target of keeping inflation at around 2 percent, even as inflation in the euro area is currently at 6.9 percent. The ECB has already raised interest rates by 3.5 percentage points since last July, but the full impact takes time to feed through, and more rate hikes are expected in the future. With analysts predicting up to three more quarter point increases at upcoming meetings, borrowers, particularly tracker mortgage holders, may face significant monthly repayment increases in the years ahead. While there is evidence of profiteering by some firms, it is challenging for governments to control prices, and most markets operate freely or are subject to regulatory competition rules. Cutting spending or hiking taxes could help control inflation, but the main responsibility remains with central banks like the ECB. Overall, while higher interest rates can help bring down inflation, they also result in higher costs for households and a potentially damaging cycle of higher wages and prices.