How can increasing interest rates really help curb inflation?

The continued rise in interest rates is making hard times even more difficult for many Canadians – on purpose

Once again, the Bank of Canada has raised its benchmark interest rate — this time to 4.25 percent — assuring us that a seemingly endless series of hikes will eventually help tackle inflation.

It has a ways to go. Inflation is currently 6.9 percent and the central bank wants it back by 2 percent.

But for many Canadians, all they see is gas and food and almost everything else remains more expensive than before, while mortgage rates soar.

CBC News readers have been asking: So how exactly can increasing interest rates help? According to economists, making it harder to buy goods is part of the plan.

Why did the Bank of Canada increase interest rates so much?

In 1991, the Bank of Canada and the Canadian government decided that "low, stable, and predictable inflation" would be best for Canadians—and they agreed that the target inflation rate was two percent.

That's roughly in Canada for the last 25 years.

But about a year ago, inflation started rising—and rising, and rising—due to a number of factors, including supply chain problems due to pandemic lockdowns, the war in Ukraine, and climate change.

To bring it down, Bank of Canada Governor Tiff Macklem said interest rates would have to go up.

"It's a bit counterintuitive for Canadians," he told CBC's Peter Armstrong last month.

"Their rent is up, their groceries are more expensive, gas is more expensive. And now it's costing them more to borrow. So how does that work? Yeah, it slows down spending. It makes anything you buy on credit more expensive. So you you step back and it's helping to balance the economy and it's going to ease those price pressures."

And that's the point.

The Bank of Canada wants people to buy less stuff and slow the economy. When the economy slows down, he said, prices will fall.

At the same time, there was a tacit acknowledgment that it would hurt.

"Our economy will slow down as the central bank continues to move to tackle inflation," Finance Minister Chrystia Freeland said in October.

"There will be people whose mortgage payments will go up. Businesses will no longer thrive the way they have since we left our homes after the COVID lockdown and returned to the outside world. Our unemployment rate will no longer be at that record low."

How can raising interest rates slow inflation?

Macklem said the economy was still "overheated" - with high demand and low supply. And the difference between the two drives the price up.

So in the central bank's rationale, if we can reduce demand -- make Canadians want to buy less -- there will be less pressure on supply.

"We do need to slow down the economy," he said. "We don't want to slow it down. We don't want to make this any more difficult than it has to be."

But at the same time, he said, if they did it half-heartedly, it would just prolong the pain.

Wouldn't it be more difficult to pay off my mortgage or utilities and buy necessities like food and gas?

For now, yes. And Sheila Block, senior economist at the Canadian Center for Policy Alternatives, points out that inflation has very different impacts depending on a person's income level.

"The cost of food, rent, gas - everything has exceeded the overall level [consumer price index]," he told Power and Politics.

"And it's really going to have a big impact on low-income people who spend a large part of their income on essential things. And also people who don't have that kind of cushion to deal with this."

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