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how does interest rate affect inflation
Does a high interest rate push prices back down? Not really. Inflation is how fast prices climb, so a rate hike's job is to flatten the line, not reverse it.
After a hike, prices keep rising, just more slowly. A real fall in the price level is deflation, which central banks try to avoid. The goal is a gentler slope.
So how does a hike bend that line? Borrowing gets pricier, so households and firms buy fewer homes, cars and factories. Spending cools, and sellers can raise prices less easily.
Take a three hundred thousand dollar, thirty-year mortgage. At three percent the payment is about twelve hundred sixty-five dollars a month. At seven percent, about two thousand. Same house, nearly sixty percent more.
Now the real test. In June 2022 American inflation hit nine point one percent, the highest since 1981, after starting 2021 at about one and a half percent.
The Fed raised its rate eleven times between March 2022 and July 2023, from near zero to above five percent. Inflation fell to three percent by June 2023, as rates rose and supply chains eased.
So the whole chain on one board: a higher rate makes loans costly, spending cools, and prices climb more slowly. Slower, not lower.
Next time inflation is in the news, picture a hill: a rate hike makes it less steep, it does not carry you back down.