How Interest rates really influence inflation

How do interest rate rises bring down inflation. This is something we never think about since superficially it is obvious: people and businesses have less money to spend, so they buy less, putting downward pressure on prices, and then less stuff is made so unemployment rises which further reduces demand and also puts downward pressure on wages. But is that how it really works?

In most of the Western world central banks have been using interest rates to influence inflation. Also there is a surge in house prices and rental rates. This has led to a lot of discussion in Australia, and probably everywhere, about the "housing crisis". In the course of this we've had two contradictory points.

• Looking at history, there is a good correlation of higher unemployment with lower house prices and rental rates. And housing costs are a big part of the basket of goods that determine the inflation rate.
• Yet housing supply is very inelastic. Going from increased demand to higher prices to the building of more houses takes years.

The real link is that there is no shortage of accomodation. If you lose your job then, force majeure, you can't pay the rent or the mortgage. You move back in with your parents or to your brother's garage, or something like that. Quite quickly the supply of rental properties and houses for sale can rise. On the other hand suppose employment is rising, as it did rapidly after the pandemic. Often when people get a job they will want to move, to be closer to the new job, or to widen their romantic opportunities, or just to have more freedom or comfort. Then we saw housing prices rise despite the rising interest rate, and rental rates soar as availability plummeted.

So it turns out that accommodation is quite elastic. Which is lucky because that is the service that is most directly affected by interest rates. If the central bank can get unemployment back where it wants it then the housing crisis will fade away.

However this is a totally unsatisfactory situation. We have one arm of government, Centrelink in Australia, making the life of the unemployed hell, trying to force them to find work, while another arm of government is trying to make sure that work is not available.

I won't make my normal mistake of coming up with a glib solution off the top of my head. But I will say this: When circumstances, such as a pandemic or a drought, have the effect that total production of goods and services is forced to fall, then the government needs to start the uncomfortable conversation of how the burden of reduced income and consumption is to be equitably shared. The current system of slamming the people at the bottom who struggle to keep a job is morally unacceptable.