Inflation & Central Banks

Wise Up in 60 Seconds – Central Banks: Misunderstood, But Critical

• What They Do: Central banks manage a nation’s money supply, interest rates, and financial stability. Their main goals are price stability, full employment, and stable financial systems.
• Why They Matter: They can cool overheating economies (high inflation) or stimulate growth in recessions, acting as a brake or gas pedal for the economy.
• Popular Myths vs. Reality:
  • Myth: Central banks create inflation.
  • Reality: They respond to it. Inflation can come from war, supply shocks, or fiscal policy, not just central bank actions.
  • Myth: They have quick fixes for every economic problem.
  • Reality: Central banks work with blunt tools like interest rates, which take months or years to fully impact the economy. They can’t solve supply chain disruptions or energy crises.
• The Real Challenge: They balance a delicate act, if they raise rates too quickly, they risk recession. If they act too slowly, inflation spirals.
• Bottom Line: Central banks aren’t perfect, but without them, modern economies would be far less stable.

1  A 50 Year Loop of Price Panic

1.1 The Great Inflation (1965‑1982)

• Causes: Vietnam War spending, oil embargoes (1973, 1979), wage‑price indexation.
• Peak: U.S. CPI hit 14.8 % in March 1980.
• Cure: Paul Volcker’s Fed hiked the federal funds rate to 20 %; recession followed, inflation broke.

1.2 The Great Moderation (1983‑2007)

• Stable prices: CPI hovered near 2‑3 %.
• Globalization & tech: Cheap imports, just‑in‑time inventory, and IT efficiency.
• Credible Fed: Markets trusted the 2 % anchor.

1.3 Post‑GFC Disinflation (2009‑2019)

• Zero lower bound: Rates near 0 %, QE flooded reserves.
• Paradox: Massive money supply but tepid CPI (<2 %) velocity collapsed.

1.4 Pandemic Spike (2021‑2023)

• Demand shock: Fiscal stimulus (≈ 25 % of U.S. GDP).
• Supply shock: Chips, shipping, labor shortages.
• Result: CPI peaked at 9.1 % (June 2022), highest in 40 years.

1.5 The Current Plateau (2024‑2025)

• Core inflation cooled toward 3 %, but shelter & services remain sticky.
• Debate: Soft landing vs. higher‑for‑longer vs. stagflation 2.0.

2  How Central Banks Fight Inflation

Central banks favor the blunt‑force rate tool; it’s predictable, legal, and understood by markets. QT amplifies by draining liquidity. Both risk overshooting into recession.

3  The Wage‑Price Spiral: Myth or Menace?

Classical fear: workers demand higher pay → firms raise prices → cycle. Modern data: Union density fell from 20 % (1983) to 10 % (2024) in the U.S.; empirical spirals rare post‑’90s. But services inflation tracks wages closely (e.g., healthcare, hospitality). Central banks watch average hourly earnings like hawks.

4  Global Forces: A Tug‑of‑War on Prices

1. Demographics: Aging societies save more, spend less, dis‑inflationary (Japan).
2. Technology: Automation & e‑commerce drive price transparency, squeezing margins.
3. Reshoring & protectionism: Tariffs and supply‑chain redundancy raise costs short‑term.
4. Climate transition: Carbon pricing and green‑tech subsidies could be inflationary near‑term, deflationary long‑term as renewables cheapen energy.

5  The 2 % Target: Holy Grail or Ball & Chain?

Set in the early ’90s (New Zealand first, Fed formalized 2012). 2 % balances:

• Above zero → avoids deflationary trap.
• Low enough → preserves purchasing power & planning.

Critics argue for 3‑4 % target to give rate‑cut cushion at next recession. A higher target risks un-anchoring expectations: central banks guard that credibility zealously.

6  Crypto, CBDCs & Shadow Money

Digital assets add parallel payment rails; stable coins mimic bank deposits. If households shift enmasse, central banks lose grip on the money supply. Central Bank Digital Currencies (CBDCs) are pre‑emptive strikes: offer safe digital cash, keep policy transmission intact.

7  Policy Prescriptions Beyond the Central Bank

• Supply‑side investment: Infrastructure, childcare, immigration reform—raises productive capacity, moderates price pressures.
• Targeted fiscal aid: Cash to the most price‑sensitive households beats helicopter drops that stoke demand broadly.
• Automatic stabilizers: Index tax brackets & benefits to inflation to avoid bracket creep.

Central banks can’t alone cure supply shocks; coordination beats blame games.

8  Personal Playbook Against Inflation

1. Inflation‑protected securities (TIPS): Principal adjusts with CPI.
2. Hard assets: Real estate, commodities (but watch cyclicality).
3. Variable‑rate debt: Lock in fixed loans before hikes bite.
4. Skill inflation: Upgrading tech & analytical skills raises your pricing power in labor markets.

References

1. U.S. Bureau of Labor Statistics. (2025). Consumer Price Index Historical Tables.
2. International Monetary Fund. (2024). World Economic Outlook: Navigating Sticky Inflation.
3. Federal Reserve Board. (2023). Monetary Policy Report.
4. Blanchard, O. (2024). "Should We Raise the Inflation Target?" Brookings Papers on Economic Activity.
5. Summers, L. H. & Furman, J. (2023). "How Persistent Are Post‑Pandemic Inflations?" NBER Working Paper 30931.