How does increasing interest rates actually help curb inflation?

Once again, the Bank of Canada has raised its benchmark interest rate — this time to 4.25 per cent — reassuring us that its seemingly unending series of hikes are going to eventually help take the bite out of inflation. 

It has a ways to go. Inflation is currently 6.9 per cent and the central bank wants it back at two per cent. 

But for many Canadians, all they’ve seen is gas and food and just about everything else stay more expensive than ever, while mortgage rates soar.

CBC News readers have asked: So how is increasing interest rates actually supposed to be helping? According to economists, making it tougher to afford things is part of the plan.

Why is the Bank of Canada increasing interest rates so much?

In 1991, the Bank of Canada and the Canadian government decided that “low, stable and predictable inflation” would be the best thing for Canadians — and they agreed that a target inflation rate was two per cent. 

That’s around where it’s been in Canada for the past 25 years. 

But about a year ago, inflation started to rise — and rise, and rise — due to several factors, including supply chain issues that resulted from pandemic lockdowns, the war in Ukraine and climate change.

To get it down, Governor of the Bank of Canada Tiff Macklem says interest rates must go up. 

“It’s a bit counterintuitive for Canadians,” he told CBC’s Peter Armstrong last month. 

“Their rent’s going up, their groceries are more expensive, gasoline is more expensive. And now their borrowing costs are more expensive. So how does that work? Well, that does slow spending. That makes anything you buy on credit more expensive. So you you pull back and that helps get the economy balanced and that’ll relieve those price pressures.”

And that’s the whole point.

The Bank of Canada wants people to buy less stuff and slow the economy down. When the economy slows down, it says, prices will come down. 

At the same time, there is a tacit acknowledgement that it’s going to hurt. 

“Our economy will slow as the central bank continues to step in to tackle inflation,” said Finance Minister Chrystia Freeland in October. 

“There will be people whose mortgage payments will rise. Business will no longer be booming in the same way it has been since we left our homes after the COVID lockdowns and went back out into the world. Our unemployment rate will no longer be at its record low.”

How does raising interest rates slow inflation?

Macklem says the economy is still “overheated” — with demand high and supply low. And the difference between the two drives prices up.

So in the central bank’s reasoning, if it can get demand down — get Canadians to want to buy less — that pressure on supply will ease. 

“We do need to slow the economy,” he said. “We don’t want to over-slow it. We don’t want to make this more difficult than it has to be.”

But at the same time, he said, if they do it in a half-hearted way, it will just prolong the pain.

Won’t it just make it harder to pay my mortgage or utilities and buy necessities like food and gas?

For now, yes. And Sheila Block, senior economist at the Canadian Centre for Policy Alternatives, points out that inflation has a really different impact depending on a person’s income level.

“The cost of food, rent, gas — all of those have paced above the overall [consumer price index] rate,” she told Power and Politics.

“And that is really going to have a tough impact on those lower-income people who spend a larger share of their income on those essentials. And also people who don’t have that kind of cushion to ride this out.”

WATCH | Should this be the last interest-rate hike?  

Could this be the final rate hike from the Bank of Canada?

Sheila Block, senior economist at the Canadian Centre for Policy Alternatives, and Jean-François Perrault, chief economist at Scotiabank, joined Power & Politics Wednesday to discuss the Bank of Canada’s seventh rate hike of the year.

Is hiking interest rates the only way to get inflation down? 

Not according to economist Jim Stanford. The director of the Centre for Future Work told CBC News that a broader mix of policies is needed. 

“I think that our tool-kit itself needs a more diverse set of tools.”

Stanford says the government needs to introduce longer-term structural policies to address what he calls “the true causes of this inflation” which he says include “supply chains, energy price shocks, and the housing crisis in most parts of Canada.”

WATCH | Jim Stanford says there are better ways to tackle inflation:

Rate hikes have had ‘zero impact’ on inflation, says economist

Jim Stanford, director of the Centre for Future Work says raising interest rates is not the only way to tackle inflation in Canada.

He says raising interest rates will do nothing to help global supply chains.

“In fact, they’ll probably make things a little bit worse because they discourage investment in new capacity and infrastructure by businesses,” he said on the CBC podcast Front Burner.

“What they will do, though, is basically throw a giant bucket of ice water over the entire economy. And we’re already seeing the signs are that we’ve seen a dramatic slowdown in employment growth. We’ve seen a dramatic slowdown in GDP growth. And this is just the beginning.“

He says it would be more effective to try and cool off “the least productive sort of froth in the economy,” such as the housing market. He suggests making better use of rules on mortgage insurance and stress tests “to cool off the property bubble without having to hammer the whole economy with higher interest rates.”

I’m hearing this slowing of the economy could send Canada into recession. 

Some economists are indeed suggesting that Canada could be headed for a recession in 2023. 

“I think a recession is both likely globally and most probable in Canada,” said former Bank of Canada and Bank of England governor Mark Carney in October.

The good news is, he also thinks it won’t be deep or long, citing the country’s strong labour market and low unemployment as reasons why Canada will do better than other countries.

WATCH | Everything you want to know but about a recession but were afraid to ask: 

Macklem is optimistic, too. 

“This is the biggest test we’ve ever had. But monetary policy works. It takes time to work. And we do have to go through a difficult adjustment.”

But he insists Canada will come out of it. 

“Growth will pick up. We’ll have solid employment growth and we’ll have low inflation.”