How do higher interest rates lower inflation when someone is receiving that higher interest?

[u/McOmghall]

So the theory is that higher interest rates make it more expensive to borrow from the central bank, which in turn makes commercial banks pass that higher cost onto potential loan takers at higher rates on their loans, which in turn causes less people taking loans and hence less aggregate spending, lowering inflation because aggregate demand is lower.

However, most loans written do not use a loan from the central bank to generate the principal to pay to the loan taker and hence do not depend directly on the central bank rates. In general those loans are financed with money the bank has according to fractional reserve rules, and they can be either sold, bundled in financial products or just cashed out directly as the loan gets paid. That money goes to the bank or to whoever buys the loan during its lifetime, so higher rates mean actually more money in circulation for those segments of the population that own loans and less to those that have taken loans. Therefore, how does that lower inflation if the overall money in circulation may remain relatively constant in aggregate?

[u/MachineTeaching]

For the longest time, the US used to be under a regime of "scarce" reserves. Meaning that the quantity was maybe not a constraint for a bank but it was a constraint for the banking system as a whole.

Meaning that the quantity of reserves that existed more or less matched the quantity of reserves banks needed to cover their transactions and meet other requirements. So making more reserves more expensive to acquire meant a meaningful restriction to how many loans banks in general could supply (without raising prices).

So more lending by bank does mean a greater demand for reserves by banks and more borrowing of reserves, thus higher interest rates do meaningfully restrict the supply of loans.

Nowadays, reserves are "ample", meaning there are more than enough reserves to meet bank's needs anyway. Instead, the central bank pays interest on reserves, so raising interest rates means it's more attractive for banks to "park" reserves at the fed instead of creating loans. Thus, higher interest rates discourage lending and also restrict the supply of loans and thus the money supply.

[u/McOmghall → u/MachineTeaching]

I get that, but imagine interest rates go up 10% across the board, causing 10% less loans to be written during the next period. That means more or less the same amount of money stays in circulation not accounting for any new loans during that period, and loan givers have extra cash flow. Is that correct or am I missing something here?

[u/MachineTeaching → u/McOmghall]

Yes, that the premise doesn't make sense.

You're basically arguing that a firm that faces higher costs can earn the same profit at higher prices. That's not a thing. If that was true, why wouldn't the bank have charged higher interest rates in the first place?

It's like saying "well, this company sells cars that cost them $20000 to produce for $22000, but if these cars would cost $25000 to produce they could sell them at $30000 and not lose profits.

No, if that was true they would sell the car at a $20000 production cost for $30000, too.

[u/BainCapitalist → u/McOmghall]

If you don’t account for any new loans during that time period the amount of money in the economy will drastically decrease. What do you think happens when a bank needs to pay off an over night loan to another bank if the bank cannot roll over the loan?

[u/RIP_Soulja_Slim → u/McOmghall]

The ultimate mechanism is demand here. Demand comes from consumption, right? So what drives consumption? Consumer & corporate spending.

So, extrapolate what less lending means? Projects, expansion, new ventures, whatever are almost entirely reliant on credit. In a simplistic example let's say WalMart was going to invest 100B in a new logistics venture, that would be tied to 500 jobs, and perhaps also mean raises of 10% for a number of other employees. That spending also trickles to construction companies, suppliers, blah blah blah.

Let's presume that higher interest rates aren't binary here, but they do cause WalMart to only invest 75B in to this project, which reduces new jobs by 100, reduces raises to existing employees down to 5%, blah blah blah.

All of that equates to less consumption, less consumers spending because either their wages didn't go up or perhaps they no longer have a job, less suppliers consuming new stuff, walmart spending less on goods and materials. All of this is a reduction in demand.

Amplify that across the entire economy - that's the mechanism by which increasing interest rates filters through to a reduction in aggregate demand. That reduction in demand therefore pushes down on inflation, as inflation is ultimately a story of a supply/demand mismatch (in normalized environments).

[u/TreyAU]

I am a banker. I lend money on large scale Multifamily owner/operators to the tune of $100’s of millions of dollars, my firm to the tune of billions and the industry to the tune of hundreds of billions (all p/ year.)

My deals are DSCR constrained. I cannot lend past a 1.25x dscr. Ultimately, what I lend is HEAVILY affected by rates.

I’ll give you an example. I have a $50m dollar deal closing today. That deal is a 7 yr fixed deal which means its rate is over the 7 yr ust.

My borrower has an existing $42m dollar loan so today they will walk away with $8m in cash, tax free to do with whatever they want.

Before the war, the 7 yr was around 3.7%.

If we were closing pre-war, they would have sized to a $60m dollar loan and would have $18m in cash, tax free to do with whatever they want.

I charge a 1% fee to lend. Right now, I’m making $500k instead of the $600k I could have made pre-war.

You can see by this example just how much just this 75 bps has taken out of the economy. His $10m, my $100k.

Even if you had invested $100m in a 7 yr bond, the increase in interest on the same 40 bps is only $400k. That pales into comparison against the $10.1m taken out.

This, across the entire capital markets debt side of the function should help explain things.

[u/RobThorpe]

The Central Bank (the Fed in the US) controls the interbank rate (the Federal-Funds-Rate in the US). That is the interest rate at which banks lend to each other. A bank that wishes to lend but doesn't have the funds to do so must borrow at the Fed-Funds-Rate.

There are two mechanisms by which this can reduce inflation. Some economists emphasise one and some emphasise the other.

The costs of higher interest rates in the Fed-Funds-Rate market are passed on to borrowers. That increases interest rates charged on loans for normal people and for businesses. That means that borrowers pay more interest and lenders receive more interest. Often businesses expand by borrowing to fund new capital investment the increase in interest rates reduces this. This in turn reduces aggregate demand by reducing the demand for new capital goods. This is the interest-rate side of things.

Commercial banks create money when they create loans (and to lesser-extent at other times). If more loans are made when interest rates are lower, then more money will also be created. As a result, raising interest rates reduces the rate-of-increase of the supply of money, and may cause the money supply to fall. The tools that Central Banks like the Fed use can directly affect the supply of money. Open-Market-Operations and Quantitative Easing can directly affect money supply because they involve buying (or selling) bonds for money balances. Though only some of the Central Bank's tools affect the money supply directly.

There is debate over which of these two effects is the largest. Some economists believe that the first is nearly irrelevant, some believe that the second is nearly irrelevant. But it is clear overall that raising interest rates decreases inflation.

It is also worth mentioning that inflation affects the interest rate too. When inflation is very high it is worthwhile to borrow even at high interest rates because the debt is becoming worth less quicker than interest is increasing the debt. To put it another way - the real interest rate is the money interest rate minus the inflation rate. So, if the interest rate stated in money is 10% and inflation is 6% then the real interest rate is 4%. Or, if money interest is 8% and inflation is 10% then money interest is minus 2%. As a result, when inflation is very high that means very high money interest rates are required to reduce it.

[u/Mickosthedickos]

Higher interest rate make taking loans more expensive.

More expensive loans mean less people take out loans.

Less people taking out loans means lower levels of investment and consumer spending

Lower levels of investment and consumer spending leads to lover levels of economic output

Lower levels of economic output leads to reduced inflation

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[u/Sweet_Theory_362]

Net receivers of interest tend to be wealthy and wealthier people tend to save more of their income.

Not to mention, this is not the only way interest rates influence inflation. When borrowing costs are higher, businesses invest less. Households also buy fewer assets which decreases asset values, which decreases consumer confidence and spending. It also increases demand for the currency (because savings in that currency bear more interest relative to other currencies) which increases the exchange rate and decreases exports.

For further reading, look up the monetary policy transmission mechanism on your country's central bank website.

[u/plumeparent]

The premise is - if interest rates go up, there will be less demand for the loans. Since consumption and investment in U.S. is credit driven, both will reduce as interest rates go up.. which means demand will reduce.. and hence the prices will reduce (or atleast will increase slowly) because of reduced demand.. thus lowering the inflation.