Low, stable and predictable
To achieve the inflation target, the Bank adjusts (raises or lowers) its key policy interest rate. If inflation is above the 2 per cent target, the Bank may raise the policy rate. This prompts banks to increase interest rates on their deposits, loans and mortgages. Higher interest rates encourage saving and discourage borrowing and, in turn, spending. In response, companies increase their prices more slowly or even lower them to encourage demand. This reduces inflation. Lower interest rates work in the opposite way and can help increase inflation if it is too low.

Of course, the Bank doesn’t respond to every movement in inflation or focus on prices that jump around a lot. Nor does it pay attention to one-time changes in price levels, such as those caused by a new sales tax rate. The Bank focuses on price changes that are more widespread and persistent—ones that could push inflation away from the target for a while. This is because any changes the Bank makes to the policy interest rate will take time to affect people’s spending.


Inflation and interest rates tend to move in the same direction because interest rates are the primary tool used by the Federal Reserve, the U.S. central bank, to manage inflation.

The Federal Reserve Act directs the Fed to promote maximum employment and stable prices. Since 2012, the Federal Reserve has targeted annual inflation of 2% as consistent with the stable prices portion of its dual mandate.

The Fed targets a positive rate of inflation, defined as a sustained rise in the overall price level for goods and services, because a sustained decline in prices, known as deflation, can be even more harmful to the economy. The positive level of inflation and interest rates also provides the central bank with the flexibility to lower rates in response to an economic slowdown.

In August 2020, the Federal Reserve adopted average inflation targeting. That framework committed Fed policymakers to hold inflation above 2% for a time to compensate for stretches when the inflation rate fell short of that target.

How Changes in Interest Rates Affect Inflation
When the Federal Reserve responds to elevated inflation risks by raising its benchmark federal funds rate it effectively increases the level of risk-free reserves in the financial system, limiting the money supply available for purchases of riskier assets.

Conversely, when a central bank reduces its target interest rate it effectively increases the money supply available to purchase risk assets.

By increasing borrowing costs, rising interest rates discourage consumer and business spending, especially on commonly financed big-ticket items like housing and capital equipment. Rising interest rates also tend to weigh on asset prices, reversing the wealth effect for individuals and making banks more cautious in lending decisions.

Finally, rising interest rates signal the likelihood that the central bank will continue to tighten monetary policy, further tamping down inflation expectations.

Problems With Using Interest Rates to Control Inflation
As the chart above shows, policymakers often respond to changes in economic outlook with a lag, and their policy changes, in turn, take time to affect inflation trends.

Because of these lags, policymakers have to try to anticipate future inflation trends when deciding on rate levels in the present. Yet the Fed's adherence to its inflation target can only be gauged with backward-looking inflation statistics. These can range widely amid economic shocks that can sometimes prove transitory and other times less so.