How do central banks fight against inflation?

In 2022 inflation in the eurozone reached a record level of over ten per cent. Food, electricity and heating suddenly became much more expensive. Something similar also happened in the USA, where inflation reached its highest level since the start of the 1980s. But why did prices rise so fast?

During the pandemic, factories and ports worked with interruptions, so many goods were in short supply. When the economy then opened up again, people wanted to buy a lot, but supply could not meet demand. Then came the Russian invasion of Ukraine in February 2022. The prices of gas and oil shot up, and that raised the cost of transport and the production of almost everything.

The task of central banks is to keep prices stable. The European Central Bank in Frankfurt and the US Federal Reserve have the same goal: inflation of about two per cent a year. Their most important instrument is the key interest rate. That is the interest rate at which commercial banks can borrow money from the central bank. When the central bank raises the interest rate, loans become more expensive and people spend less. Companies also invest less, so demand falls, and with it the pressure on prices.

However, central banks waited a long time, because they thought that high inflation would be only temporary. Only in 2022 did they begin to raise interest rates vigorously. The Federal Reserve raised its key interest rate to over five per cent, and the ECB to four per cent. Over time, the measures worked, and inflation in the eurozone gradually fell to around two per cent. As early as 2024 the ECB began to cut interest rates again, and shortly afterwards the Federal Reserve also did so.

For ordinary people, changes in interest rates have direct consequences. Anyone who wanted to buy a flat on credit suddenly had to pay much higher monthly instalments. Savers, on the other hand, finally received interest on their money in the bank again. Households with low incomes were particularly affected by the price rises, because they spend most of their money on food and energy. Economists nevertheless warn that new crises and tariffs could push up prices again.