Neuromodulatory control by oxytocin is essential to a wide range of social, parental and stress-related behaviours. Autism spectrum disorders (ASD) are associated with deficiencies in oxytocin levels and with genetic alterations of the oxytocin receptor (OXTR). Thirty years ago, Mühlethaler et al. found that oxytocin increases the firing of inhibitory hippocampal neurons, but it remains unclear how elevated inhibition could account for the ability of oxytocin to improve information processing in the brain. Here we describe in mammalian hippocampus a simple yet powerful mechanism by which oxytocin enhances cortical information transfer while simultaneously lowering background activity, thus greatly improving the signal-to-noise ratio. Increased fast-spiking interneuron activity not only suppresses spontaneous pyramidal cell firing, but also enhances the fidelity of spike transmission and sharpens spike timing. Use-dependent depression at the fast-spiking interneuron-pyramidal cell synapse is both necessary and sufficient for the enhanced spike throughput. We show the generality of this novel circuit mechanism by activation of fast-spiking interneurons with cholecystokinin or channelrhodopsin-2. This provides insight into how a diffusely delivered neuromodulator can improve the performance of neural circuitry that requires synapse specificity and millisecond precision.