How do interest rates affect inflation?



I have been asked the same question so many times that I now feel compelled to provide a short answer to it. First of all, depending on the current conditions within an economy, it may take some time for economic prescriptions to be successful, or sometimes they may not be effective at all against the problems. Or they can also be used to indirectly interfere with the problems from time to time.


Interest is normally used to soft land a heating economy. Although everyone loves the acceleration of growth, higher-than-expected rise in effective demand increases the general level of prices, that is inflation. This situation causes income inequality, social and moral deterioration, and artificially grows the financial statements of the public and private sectors. For this reason, monetary authorities hike interest rates to keep economy under control. When this happens, individuals tend to save money rather than spending it. Private savings of today are no cause for concern since they are tomorrow’s investments. There would be no serious deterioration in the supply-demand balance either as companies would stop expanding their activities due to increasing rates.


This applies to situations where interest rates surpass inflation and generate real gains. If consumers see that the price of the good or service they want to buy will increase at a lower rate than the interest earnings, they do not rush into buying it. They rather prefer placing their money on interest, and at the end of the maturity, they can easily buy the goods or services they have set their sights on.


However, if interest rates are not lower than the current inflation rate, but even lower than the expected inflation, instead of depositing their money in the bank, people continue to buy goods or services out of fear they would not be available in future. As the price increases continue, households start to think they save money by consuming. The same is true for businesses. Negative real interest rates lead businesses to stock up on inventory, especially if price behaviour is constantly deteriorating.


As consumption and stocking up continue, producers do not slow down and further fuel inflation. And when wages are continuously raised in line with the increasing inflation, the problem becomes unresolvable without a drastic intervention.

The US Federal Reserve is trying to bring inflation under control, at the expense of facing a recession, by blocking the effective demand with interest rate hikes. Admitting that the rate hikes so far have not yielded the desired result, the Fed says, “We will continue to introduce moderate rate hikes until prices fall back to a healthy level”. Similarly, the ECB keeps combatting inflation in a moderate but determined manner. Both institutions say that inflation is mostly supply-related, that they were late in initiating the fight against inflation, that’s why they hiked rates so drastically, but the important thing is not to allow the markets to deteriorate.


In my opinion, it is very hard to put a brake on the demand without creating the perception that the interest rates are higher than the next year’s inflation.

Therefore, I could certainly say that 2023 will be a struggle both for the US and EU economies.


“Meanwhile in Turkey…”


Although interest rates are reduced in Turkey, loan rates remain quite high. With the additions on the interest rate, banks impose a very high level of loan interest, which is almost half of the inflation rate. While cutting the policy rates, the Government increased the cost of loans and made them almost inaccessible to those in need of finance because of constant legislative changes and the peculiarity of our economic model. However, inflation has not slowed down yet. The Government obviously has an action plan based on the base effect of inflation and the probability that it will decline over time.


According to the plan, exchange rates will be suppressed, the revenues of those who earn foreign currency will be transferred to the Central Bank and sold if need be, those who buy foreign currency in large quantities and banks that impose drastic interests on loans or deposits will be warned, retail prices will be monitored, the Government will pay off some of the households’ energy bills, but as for the businesses, they will be asked to pay their energy bills in instalments. In the meantime, “selective” loan campaigns will be launched to prevent economic growth from slowing down until the elections. We will have to endure all of this so that the policy rates and deposit rates are not increased further.


I don’t know if this model can be considered heterodox, but I can easily say that it is unorthodox. It would be wrong to label every solution we apply with scientifically accepted prescriptions. Still, the method of tightening credit channels by hiking or reducing rates does not seem to have worked in the combat against inflation. In other words, neither orthodox nor unorthodox methods do not produce the intended result, worse, they lead to undesirable side effects.


While the Fed and the ECB patiently wait for a positive result, Türkiye patiently waits for the elections as it continues to implement so-called solutions that are clearly not embraced by the markets. I must say that I disagree with those who think that this policy will not continue after the elections. The policy will undoubtedly be subject to several alterations, but it certainly would remain effective.