The relationship between interest rates and inflation is one
of the most divisive topics separating economists and politicians. These two
concepts are often manipulated in political discourse, particularly by populist
leaders who seek to assign blame. As a result, we frequently hear claims such
as “high interest rates are the cause of inflation,” even though this view
overlooks key economic realities.
What Are Interest and Inflation?
Interest is the cost of borrowing money — essentially, the
price of using capital over time. In economic terms, it is the rate that
balances the supply and demand for money.
Inflation, on the other hand, refers to a sustained
increase in the general price level within an economy. It typically arises
when aggregate demand exceeds aggregate supply. As spending increases
and supply struggles to keep up, prices begin to rise across the board.
Does Interest Cause Inflation or the Other Way Around?
This question has long divided economic theory. Some schools
— notably Neo-Fisherian economists — argue that rising interest rates
cause inflation via the cost channel. According to this view, when borrowing
costs rise, businesses pass these costs on to consumers in the form of higher
prices.
While this model might appear to work in certain developed
economies under specific conditions, it fails to account for the
complexities of emerging markets like Turkey — where dollarization, exchange
rate volatility, weak institutional credibility, and fragile
consumer confidence are critical factors influencing inflationary dynamics.
Short-Term Effects: Inflationary Pressure
Indeed, in the short term, an increase in interest rates can
raise costs. Businesses borrowing at higher rates will likely pass those costs
on to consumers. For example, if mortgage rates spike to 30%, construction
firms may raise home prices to maintain margins.
This may give the impression that high interest rates
“cause” inflation — but this effect is often temporary.
Medium to Long-Term Effects: Rebalancing the Economy
Over the medium term, higher interest rates tend to reduce
borrowing and spending. This leads to a decline in aggregate demand, easing
inflationary pressure. In this sense, interest rate hikes serve a corrective
function, cooling down an overheating economy.
To summarize the process:
Higher interest → Lower demand → Less price pressure →
Inflation falls
Therefore, while interest rate hikes may appear inflationary
at first, they are in fact a crucial tool for achieving long-term price
stability.
What Happens When Interest Rates Are Artificially
Suppressed?
One of the biggest risks in economic policy is the artificial
suppression of interest rates. When rates are kept too low despite rising
inflation, demand remains strong while access to funding becomes distorted. The
result? An overheated economy, rising imports, weakening currency, and
ultimately, runaway inflation.
Turkey’s experience during 2021–2022 is a prime example.
Despite falling policy rates, inflation soared — peaking above 80% by mid-2022.
Why? Because credit-driven demand remained strong, the lira depreciated
sharply, and price expectations became unanchored.
Conclusion: From Political Rhetoric to Economic Reality
The interest-inflation relationship cannot be reduced to
simplistic cause-effect logic. Economic outcomes depend on timing, structural
context, and market confidence. Yes, high interest rates may seem painful —
especially for borrowers and investors — but suppressing them in defiance of
inflationary trends often leads to worse outcomes.
Ultimately, successful economic management requires looking
beyond short-term costs, restoring policy credibility, and acknowledging
that inflation control is not a political preference but an economic
necessity.
High interest rates may create short-term inflationary
pressure.
But suppressed interest rates allow long-term inflation to spiral.
Navigating this delicate balance is not just about numbers —
it’s about trust, transparency, and discipline.
