What inflation is, and how central banks try to tame it

If a basket of shopping cost 100 last year and costs 104 today, inflation over that period was 4 percent. Your money buys a little less than it did. Over years, even modest inflation adds up: at 2 percent a year, prices roughly double in about 35 years, and at 4 percent they double in about 18.

This explainer covers what inflation measures, where it comes from, how central banks fight it and what remains hard about the job.

How inflation is measured

Statistics offices track the prices of a large, representative basket of goods and services, from rent and bread to haircuts and bus fares. The best-known measure is the consumer price index (CPI). Economists also watch “core” inflation, which leaves out volatile items such as food and energy, to see the underlying trend.

Building the index takes several steps:

1. Choose the basket. Surveys of household spending show what people actually buy, and how much of their budget goes on each thing.
2. Collect prices. Thousands of prices are gathered every month, in shops, online and from service providers, across many regions.
3. Weight them. Items that take up a large share of spending, such as housing, count for more than items that take up a small share.
4. Compare over time. The weighted cost of the basket is compared with the same basket in an earlier period, and the percentage change is the inflation rate.

The basket is updated periodically as spending habits change.

Why prices rise

• Demand runs ahead of supply. When people and businesses want to buy more than the economy can produce, sellers can raise prices.
• Costs go up. Higher prices for energy, materials or wages can be passed on to customers.
• Expectations. If everyone expects prices to rise, workers ask for higher pay and firms raise prices in advance, which can make inflation self-reinforcing.

Money matters too. Over long periods, an economy in which the supply of money grows much faster than the output of goods and services tends to see rising prices. In extreme cases, governments that pay their bills by creating money have produced hyperinflation, as in Germany in the early 1920s and Zimbabwe in the late 2000s, when prices rose so fast that savings were wiped out and people struggled to use the currency at all.

A short history of the modern approach

In the 1970s, many rich countries suffered a painful mix of high inflation and weak growth, partly triggered by sharp rises in oil prices. In the United States, inflation reached double digits. Under chair Paul Volcker, the Federal Reserve raised interest rates to very high levels in the late 1970s and early 1980s. Inflation came down, but at the cost of a deep recession and high unemployment.

Afterwards, many governments gave their central banks more independence from day-to-day politics, on the idea that decisions about interest rates are better made by officials who do not face an election next year. New Zealand became the first country to adopt a formal inflation target, in 1990, and many others followed.

Why a little inflation is the target

Many central banks, including the US Federal Reserve, the European Central Bank and the Bank of England, target inflation of about 2 percent. Zero is not the goal, because falling prices (deflation) can lead people to delay spending, which can deepen a downturn. A small positive rate also gives central banks more room to cut interest rates in a slump, and allows for the fact that price indices may slightly overstate true inflation as products improve in quality.

Central banks differ in their wider mandates. The Federal Reserve, for example, is asked by law to pursue both maximum employment and stable prices, while the European Central Bank’s primary objective is price stability.

The main tool: interest rates

When inflation is too high, a central bank raises its key interest rate. Borrowing becomes more expensive, so households and businesses spend and invest less, and demand cools. When inflation is too low, it cuts rates to encourage spending.

The effect is slow: changes in rates can take a year or more to work through the economy. The economist Milton Friedman famously described monetary policy as working with long and variable lags. That is why central bankers watch forecasts closely, and why they are sometimes criticised for acting too late or too much.

Rates are not the only tool. After the 2008 financial crisis, when interest rates were already close to zero, several central banks used quantitative easing, buying large amounts of government bonds and other assets to push down longer-term borrowing costs. Central bankers also use communication itself as a tool: signalling future plans can shift expectations before any rate actually changes.

Common misconceptions

• “Inflation falling means prices are falling.” Not so. Lower inflation means prices are rising more slowly. Prices actually falling is deflation.
• “The official figure is my inflation rate.” The index reflects an average household. Someone who rents, drives a lot or spends a large share of income on food may experience a different rate.
• “Central banks control prices directly.” They do not set the price of anything you buy. They influence borrowing costs and expectations, which affect demand, which in turn affects prices.

What it means for you

Higher rates usually mean better returns on savings and higher costs for new loans and variable-rate mortgages. Lower rates work the other way round. Over time, inflation also reduces the real value of cash kept under the mattress and of debts fixed in money terms, which is one reason economists distinguish between nominal figures and “real” figures adjusted for inflation. This is general information, not personal financial advice.

What is still uncertain

The surge in inflation in many countries after the Covid-19 pandemic, and the sharp rate rises that followed from 2022, reopened old debates. Economists still disagree about how much of that surge came from supply disruptions and energy prices and how much from strong demand and government support, and therefore about how quickly central banks should have responded. How firmly the public’s expectations stay anchored, and exactly how long rate changes take to bite, remain questions without precise answers.