I do not understand in the current post covid scenario, where inflation is being caused primarily because of businesses and utilities increasing prices across the board, how federal or national reserve banks increasing wholesale interest rates does anything at all except drive people to the wall?
It would seem that Inflationary pressures today are nothing to do with discretionary spending so how does increasing Interest rates help and not hurt more?
TIA
In: Economics
Inflation is, generally, caused by too much money chasing too few goods. Interest rates are, generally, used as a tool to control the ups and downs of the economy. Raising interest rates makes it more expensive to borrow money, and thus more expensive to invest/spend money. On the large scale, this slows down economic activity, reduces demand for everything, and brings inflation down.
Inflation is rarely caused by discretionary spending (although the post-covid income boom + still-slow supply lines was part of it), but interest rates aren’t moved to change discretionary spending. They affect bank loans, mortgages, and most of all, the loans businesses take out to invest elsewhere.
You’re referring to what people are calling “greed-flation”, which is when a business takes advantage of the economic environment to raise prices without any sort of supply chain reason to do so. This is certainly happening, but it is a *response* to actual inflation, not the driving force behind it.
Inflation initially happened for boring, regular reasons, like supply chain issues and an injection of “cheap” money into economies around the world. It’s actually a textbook example of inflation: the supply chain got hit with a shock in a few key places (you may remember building materials were sky high, then computer chips) which had a ripple effect throughout the economy. Things get more expensive due to regular old supply and demand.
The textbook response is to “slow down” the economy by increasing interest rates so that you don’t get an inflation death spiral. If money is more expensive to get a hold of (bank loans, credit card rates, all way up), you are incentivizing people to hold onto their cash instead of spending it. This directly combats the inflationary environment of “spend now before it becomes even more expensive!”.
Again, it is correct to say that greed-flation is amplifying the effects of normal inflation and making things worse, but it is not the main reason these things are happening, and the government is not wrong for raising the rates.
TLDR – The government has no direct control of the interest rate. What they have control of is how much money they print. Every week, government prints a certain amount of money. Then, there is an auction where supply and demand figures out what the interest rate will be. If too much was printed, the interest rate is lower. If they print less, the interest rate is higher. That printed money is then used by the government for stuff like government workers, contracts, payments like social security, etc.
Because government has no direct control of the interest rate, multiple things happening at the same time can result in the temporary appearance that printing money is not the cause of inflation. Politicians are eager to convince you of that so they can print more. If you had a money printer, you would benefit by convincing everyone else that printing money for yourself will not cause inflation.
With all else being equal, inflation is not possible if no new money is printed. But not all else is equal. For example, if US govt stopped printing all money tomorrow, inflation can still increase if other countries decide to dump US bonds. But things like this is temporary because other countries have a limited number of US bonds and the contribution towards inflation for this method has a maximum impact.
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