EDUCATION ARTICLES

When inflation rises, central banks use interest rates to control inflation rates. Therefore, we notice that there is a clear relationship between inflation rates and interest rates as interest rates and inflation rates tend to move in the same direction always. Every country has a specific target for inflation rates. For example, the United States has a target of 2% for annual inflation, so that inflation in the country does not exceed this rate, and also that it is always in the positive region, i.e. above zero, so that interest below zero may harm the economy because it enters a state of deflation. Most countries measure inflation using the core consumer price index on a monthly and annual basis. The US Federal Reserve also uses these indices but has a particular favorite being the PCE price index.

How do interest rates affect inflation?

When banks raise interest rates, they offer more risk-free money (in the form of interest), which limits the financial supply available to purchase riskier assets. As they, the central banks, attract capital at the rate of interest to reduce the money supply in the economy, which limits the available liquidity and thus the gradual control of inflation. It's just that central banks are raising the costs of borrowing which makes it unattractive which makes both the consumer and business owners less attracted to borrowing from banks. Continuing to raise interest rates will eventually reduce expectations about inflationary pressures in the country. We say in this case that the central bank takes a restrictive policy to limit the money in the economy to control inflation rates at its targets.

Is using interest rates to reduce inflation a problem?

Central banks usually react late to inflation. Where you may delay in raising interest to curb inflation or increase it exaggeratedly, which negatively affects economic growth. Timing and assessment of the current economic situation is one of the most important factors for the success of interest rates in this very important task.

Conclusion

Both the interest rate and inflation move in one direction, but with a kind of delay, because policy makers usually need data to know the economic situation, and this data may need months for the vision to become clear to them. On the other hand, interest rates need time to affect the economy effectively and herein lies the problem. The effect of raising or lowering interest is not felt at the moment of raising or lowering it, but rather after months. Last month, the US Federal Reserve fixed the interest rate, although it did not reach its target around 2% (now it has reached 3%), in order to assess the situation and not to raise the rate unnecessarily, which may negatively affect economic growth. High interest rates are useful in controlling high inflation, which in turn may lead to weaker economic growth, which may lead to lower inflation and then the need to lower interest rates.

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