Inflation means a rising price level, so it is about change. When inflation is described as stable, it means that prices keep rising at a constant rate, not that prices themselves are stable.

It is measured with a basket of goods that reflects typical household spending. In Germany, for example, the basket is updated every five years because people’s spending habits change too. The inflation rate shows how much more expensive the basket has become compared with a year earlier, in percent.

In the US and Europe, 2% is a monetary policy convention, not a law of nature, but it was not chosen at random. A target above zero creates a buffer against deflation, meaning falling prices. In that case, households and businesses hold off spending because things will soon get cheaper, and they do not invest because they expect little return. The economy grinds to a halt, which is exactly what everyone wants to avoid.

A little inflation has other advantages too. Wages are hard to cut, so mild inflation helps wages and prices adjust. It also eases the burden on borrowers with a fixed interest rate, because the debt loses value in real terms, and likewise on the government as an issuer of government bonds.

Higher interest rates make loans more expensive and saving more attractive. Companies and households invest and spend less, demand falls, and prices rise more slowly. The effect is not immediate: it often takes several quarters, sometimes up to two years, for a rate hike to feed fully through to prices.

Inflation expectations matter too. If households and businesses trust the central bank to reach its target, they expect inflation of 2% over the medium term. They then adjust wage demands, pricing and rent increases accordingly, which also brings inflation down.

A central bank steers demand through the interest rate, not supply. If oil becomes scarcer and therefore more expensive, for example, a higher interest rate does nothing for the oil supply. In the short term, a central bank can therefore do little. Its reaction still matters: it shows the markets that the inflation target remains in view over the medium term. If expectations stay stable, the price shock feeds less strongly into wages and prices.

Formally, central banks are independent. In the euro area, for example, governments may not give the ECB instructions, and the central bank is prohibited from financing governments directly. In practice, though, politics still plays a part: in both Europe and the US, politicians appoint the heads of central banks and the members of their decision-making bodies. Central banks also have to explain themselves to lawmakers regularly, and they have to consider whether higher interest rates could push heavily indebted governments towards a debt crisis.

Credibility is the key here: it is monetary policy’s greatest asset and its most important tool. If political interference damages it, the consequences for the economy are far-reaching, because markets then expect higher inflation and interest rates rise for everyone.

Quantitative easing is a monetary policy tool for when the key interest rate has hit its minimum (which can also be negative). The central bank then buys large amounts of bonds on the secondary market, for example government and corporate bonds. It buys them from banks and investors rather than directly from the government, since that would be direct government financing. This extra demand holds yields on these bonds steady or pushes them lower. The aim is to lower interest rates across all financial markets and so give the economy a push. As a side effect, governments pay less on their debt. Central bank balance sheets keep growing as a result. Shrinking them again takes years: if the central bank withdrew liquidity too quickly, the markets could overreact.