How higher interest rates affect inflation

The Bank of Canada controls inflation by adjusting the policy interest rate

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Keeping inflation stable and predictable is a key part of the Bank of Canada’s work to support the Canadian economy. The main way the Bank does this is through changes to its policy interest rate.

Inflation is the persistent rise in the average prices of goods and services over time. Think about the cost of new clothing and how the price goes up each year. Measures of inflation look at how fast that price grows, as well as the prices of other goods and services across the economy.

When inflation is high, firms need to spend more to buy raw materials and transform them into finished products. The costs to ship goods and operate retail stores also go up. All of that can push consumer prices even higher.

Prices that grow too fast make it harder for households to budget for groceries, fuel and other essential goods and services. High inflation is especially difficult for people with low or fixed incomes. That’s why keeping inflation stable and predictable for Canadians is so important.

The Bank sets a 2% inflation target because when inflation is near this level, prices are more stable and that helps the economy function better. The primary tool the Bank uses to control inflation is the policy interest rate. A higher rate helps decrease inflation and a lower one helps it rise.

Inflation affects everybody, but not everyone is affected in the same way—or to the same extent. Click on a photo to learn about how inflation impacts individual households in different ways.

How changes to the policy interest rate work

An increase in the Bank’s policy interest rate reduces demand for goods and services. That decreases inflation by slowing how fast prices rise, but this takes time to happen, usually about 12 to 18 months.

Here’s how it works: Canada’s financial institutions borrow money from one another to settle payments at the end of every day. The policy rate determines the interest charged on this lending, which then influences the rates financial institutions charge on things like mortgages and business loans.

Sectors of the economy that are most sensitive to changes in interest rates are the first to feel the effects of changes in borrowing costs. For instance, people often borrow money to make a large purchase like a new vehicle. An increase in the policy rate makes auto loans more expensive. Fewer people take out these loans, which decreases demand for vehicles.

With fewer vehicles being sold, production of new vehicles slows. That means less demand for auto parts, fewer hours for factory workers and lower pay for salespeople who earn commission. All of these workers have less money to spend and that decreases overall demand in the economy. Other sectors like housing and home appliances would feel similar effects.

Learn more about the stabilizing effect of low inflation in this speech by former Deputy Governor Paul Beaudry and about how corporate price-setting behaviour influences inflation in this speech by Deputy Governor Nicholas Vincent.

Inflation works as a kind of feedback loop. Low inflation encourages low inflation—and economic stability. High inflation does the opposite—it encourages more inflation and can destabilize the economy.

When inflation is high, businesses increase prices more often to keep up with rising costs. When this happens, consumers have more difficulty knowing whether a price increase truly reflects a change in costs. This affects consumer behaviour. People are less likely to shop around if they think that all prices are increasing, and retailers don’t feel the need to keep their prices low to stay competitive. That allows stores to raise prices even higher, regardless of whether they need to.

But prices don’t change as often when inflation is low. Consumers are more likely to notice increases and shop around when they think a price is too high. This encourages competition. Companies are more reluctant to raise prices, which helps keep inflation low.

How higher interest rates affect spending

Higher rates make it more expensive for people to maintain their existing debt. This reduces the amount of money that they have to spend and, over time, that reduces demand throughout the economy.

One example of how this works is people with variable rate mortgages. Although most of these people pay a fixed amount each month, some have payments that change with interest rates. Increases in interest rates increase the amount people with variable payments spend on their mortgage each month. This reduces the amount of money they have for optional, or discretionary, spending. For instance, they might choose to eat in instead of dining at a restaurant, or watch a movie at home rather than at a cinema.

While higher rates reduce spending on optional purchases like luxury goods or travel, they have less of an effect on purchases of day-to-day necessities. Demand for groceries doesn’t change much when households have less money in their pockets because people need to eat. The same is true for other important services like internet and mobile service. So, a higher policy interest rate takes longer to slow the growth in prices for essential goods and services.

How higher interest rates affect savings

Higher rates encourage people to save more money because financial institutions offer higher interest rates on savings. Investment products like guaranteed investment certificates, called GICs for short, and high-interest savings accounts offer better returns when rates are higher. That makes saving money more attractive than spending it.

This increase in savings reduces demand for goods and services. With less demand, retailers don’t raise their prices as quickly and inflation slows.

How lower interest rates stimulate the economy

When inflation is too low, it is also bad for the economy. Decreasing the policy interest rate can stimulate economic activity and cause inflation to rise. Lower interest rates encourage people to spend more and save less. Lower rates reduce the amount needed to pay off debt and that means more people will borrow money for major purchases like a new vehicle. This encourages manufacturers to build more vehicles. Demand for auto parts, hours for factory workers and commissions for salespeople all go up. These workers have more money to spend and that increases overall demand in the economy. Lower rates also reduce incentives to save money because returns are lower and that encourages people to spend more of their money. This is how lowering the policy interest rate increases demand in the economy and causes inflation to rise.

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