Monetary policy

The other great lever over the economy belongs not to elected governments but to central banks, and it works through the price and quantity of money.

Monetary policy is the management of the money supply and interest rates by a central bank to pursue goals such as stable prices and full employment. By making money cheaper or dearer, the central bank influences borrowing, spending, and investment throughout the economy.

How it works

The main instrument is the interest rate the central bank sets, which ripples out to the rates households and firms face. Lowering rates makes borrowing cheaper and saving less rewarding, encouraging spending and investment to stimulate a weak economy. Raising rates does the reverse, cooling demand to restrain inflation. When rates reach their floor, central banks turn to unconventional tools such as quantitative easing, buying assets to inject money directly.

The primacy of inflation

In most advanced economies, the central task of monetary policy has become controlling inflation, usually around a stated target. The hard-won lesson of the twentieth century was that letting inflation run loose is deeply damaging and hard to reverse, so central banks were given independence and a mandate to keep prices stable. Much of their craft is managing expectations: if people trust the bank to hit its target, that belief helps make it true, which is why credibility is treated as the bank's central asset.

Power and limits

Monetary policy is powerful but blunt and lagged. It acts on the whole economy at once, cannot target particular regions or sectors, and works with delays of many months, so the bank must act on forecasts of where the economy is heading rather than where it is. It can also be undermined: in a liquidity trap, rate cuts lose their force, and against supply shocks it faces the painful trade-offs of stagflation.

Monetary policy, conducted by independent central banks, has become the front line of macroeconomic management in normal times, with fiscal policy often in reserve. Its mix of great influence and real limits is why central bankers, once obscure technocrats, have become among the most closely watched figures in economic life.