Nib asked
How do central banks control inflation?
They set no prices. They move one short-term interest rate, which cools spending and shapes expectations, and it works with a delay and only partly on supply shocks.
7 steps, drawn by Nib. Read it here, or watch him draw it. Updated .
1one number
A central bank does not set prices. It sets one number, a short-term interest rate, and tries to steer inflation by moving that.
2the chain
Raise the rate and loans cost more, so households and firms spend less. With weaker demand, businesses struggle to raise prices, and inflation cools, after a delay.
32022 test
In June 2022 US inflation hit 9.1 percent, the highest since 1981. The Fed was already raising its rate from near zero, and went on to five and a quarter to five and a half percent.
4what worked
By June 2023 inflation was 3 percent. Economists still debate how much came from the rate hikes and how much from easing supply problems.
5expectations
Another tool is belief. The Fed has stated a 2 percent goal since 2012, the European Central Bank aims for 2 percent too, and trust in it keeps raises modest.
6the limits
Rates work best on too much demand. After a supply shock, like an oil shortage, higher rates cannot make more oil. They only cool demand, at some cost to jobs.
7the whole idea
So: a central bank sets one rate; loans cost more, spending slows, and inflation falls later. Trust in its 2 percent goal helps, and the price is slower hiring.
A central bank cannot set prices; it moves one interest rate, and through spending and belief, with a delay, it steers inflation.