The Relationship Between High Interest Rates and Inflation: Exploring the Truth

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There is no consensus that high interest rates can lead to higher inflation. However, there is more truth to it than meets the eye.

The thesis that high interest rates lead to higher inflation was famously put forward by Turkish President Erdogan for political reasons. As soon as the election was won, the key interest rate was raised from 8.5% to 17.5%. If even the figurehead of the thesis didn’t really believe in it, it seems hopeless to argue exactly for it.

It makes no sense to associate higher interest rates with higher inflation. If interest rates rise, this has clear price-lowering consequences. If credit becomes more expensive, less is invested. Investment is a form of demand. If, for example, a factory is not built because interest rates are too high, there is also no demand for the corresponding building materials and labour.

Higher interest rates also affect household consumption. Consumer credit is quickly becoming unaffordable. Consumption on credit becomes unattractive or simply no longer affordable. If interest rates are high, it is also more attractive to save money. If people save instead of consume, demand falls.

High interest rates lower inflation. The condition for this is that higher interest rates also reach the economy. There are currently problems with this. Banks hardly pass on higher interest rates on accounts. Saving remains unattractive. During the pandemic, many households and companies also took out cheap loans. The need for new loans at higher interest rates is low.

As a result, monetary policy will work more slowly in this cycle, but it will work. It remains to be seen whether monetary policy can be held responsible for the trend change in inflation. The inflation trend also differs by region. Although inflation is falling in the eurozone, core inflation has so far resisted a downward trend reversal (Chart 1). The USA, on the other hand, is on the right track (Chart 2).

The trend in Canada is particularly interesting. Canada has defeated inflation. More or less all price indices show inflation that has returned to a normal level. In contrast to other countries, Canada has a very special inflation rate: the inflation rate that excludes interest on real estate loans.

This inflation rate is currently the lowest compared to headline inflation or inflation excluding housing. Conversely, this means that inflation including interest costs is higher. Higher interest rates practically lead to higher inflation. This is because interest costs are taken into account. If one understands credit as well as services and goods as a category whose price can rise, higher interest rates automatically lead to higher price levels.

No central bank thinks of considering the price of money in this way. Although the price level of money rises with interest rates, it is excluded from consideration. This is central to monetary policy. For households, however, it makes no difference whether the budget is tight because of higher goods prices or higher interest costs.

Thinking of inflation as getting less for the same money, higher interest rates increase inflation for households. Therefore, higher interest rates to combat inflation in goods and services are not wrong. Central banks practically exchange one price level for another. A higher price level of money should ensure a lower price level for goods and services. Higher interest rates increase the price level, just not what is generally meant by inflation.