Paul Mueller – Central Banks and Inflation
My colleague, Dr. Dave Hebert, wrote a nice overview of different types of inflation and how they can affect people. He pointed out that the rate of inflation can be high or low as well as anticipated or unanticipated. He also explained how inflation is fundamentally a monetary phenomenon: too much money chasing too few goods.
In this piece, I’ll explain some of the mechanics behind how central banks can stoke inflation unintentionally. I’ll also raise several phenomena that ordinary citizens can keep an eye on to determine whether their central bank is acting responsibly or recklessly.
Let’s start at the most basic level. How do central banks increase or decrease the money supply? They primarily do so by purchasing government debt (bonds) with newly created money – really just an electronic entry on their balance sheet – or by selling bonds into the market and thereby ‘extinguishing’ the money they receive from the sale, in effect pulling money out of circulation.
Before the 2008 Global Financial Crisis (GFC), central banks like the Federal Reserve could not manage the money supply by simply buying or selling as many bonds as they liked. Significant buying or selling of bonds will affect the price of bonds, and correspondingly the market interest rate on those instruments.
When a central bank sells bonds to reduce the money supply, they drive down the price of those bonds, which increases the rate of return, or the interest rate, on those bonds. Conversely, when a central bank goes on a bond-buying spree, they drive up the price of the bonds, reducing their rate of return or interest rate.[1]
This partially explains why people pay so much attention to central bank interest rate targets. Changes in an interest rate target are a proxy for what is happening to the money supply. And as Hebert notes, what happens to the money supply is a proxy for what will happen to the price level. The connections between interest rate movements, money supply changes, and price levels are not tight or precise in the short-run, but they do have strong correlation over time.
A regime of low interest rates (or more precisely, of falling interest rates) suggests an expansion of the money supply and lower future rates of inflation. And a regime of rising interest rates suggests a reduction or ‘tightening’ of the money supply and lower future rates of inflation. Two bouts of inflation in the United States demonstrate how interest rate targeting monetary policy can be used. In 1980, the U. S. inflation rate rose to over 14%. In 2022, it rose to over 8%.
In 1979, President Jimmy Carter appointed Paul Volcker chair of the Federal Reserve to combat inflation. Under Volcker’s leadership, the Fed stopped buying government bonds which had been keeping short-term interest rates artificially low. In other words, the Volcker Fed allowed interest rates to rise rapidly – peaking at about 22% in December 1980. Although painful at the time, by 1983 the U. S. inflation rate was back below 3%.
Similarly, the Federal Reserve raised interest rates from less than half a percent to over five percent between 2022 and 2024 to bring down the U. S. inflation rate from over 8% in June 2022 to under 3% in May 2025. The interest rate hikes in the early 1980s and the early 2020s were accompanied by the Fed selling more bonds (or letting more bonds mature) than it purchased.
It's important to note that post GFC, most central banks changed their operating framework to decouple interest rate decisions from balance sheet decisions (deciding whether to buy or sell securities). Though they would still tend to move in the same direction (raising rates & reducing the balance sheet or lowering rates & increasing the balance sheet), these two things no longer have to move together. That decoupling was by design and made it easier for central banks to change their target interest rate.
Central bankers, in the wake of the GFC and anemic economic recovery, wanted more tools to stimulate the economy. They had already pushed short-term rates to zero or slightly below zero in the European Union, but they wanted to do more. Decoupling bond purchases from interest rate targeting allowed central banks to inject huge amounts of money into markets through large-scale purchases of assets – called Quantitative Easing. For example, the Fed bought nearly five trillion dollars of securities between March of 2020 and March of 2022 – which clearly played a role in the worst bout of inflation in the U. S. in four decades.
Central banks have kept interest rates artificially low over the past couple decades – meaning interest rates would be higher given existing market conditions if central banks were not actively intervening in financial markets. An important effect of these artificially low interest rates, and large-scale asset purchases, are that national governments have been able to borrow at remarkably low interest rates. And, as a result, most national debts have ballooned relative to the size of their economies. Between 2005 and 2025, U.S. national debt rose from 63% to about 120% of GDP, U.K. national debt rose from 45% to about 104% of GDP, Japan’s national debt rose from 175% to about 235% of GDP (Figure 1).
Inflation is a simple phenomenon with complex causes. Central banks, however, play a key role because they manage currencies and can use their ability to create money ex nihilo to intervene in financial markets and distort the cost of borrowing. We can see a mutually reinforcing cycle of central banks buying large quantities of government debt, which lowers the cost of borrowing and encourages governments to issue even more debt, which central banks then buy with new money. This cycle is fundamentally inflationary.
Citizens concerned about inflation should follow three issues with respect to their central bank. The headline inflation rate has primacy of place. But citizens should also follow interest rate target changes to understand which way the central bank is moving, towards higher or towards lower inflation. Finally, concerned citizens should keep an eye on the size of their central bank’s balance sheet and encourage the bank to reduce its footprint in financial markets.
[1] The majority of government bonds are ‘Zero-Coupon Bonds’, which means they will pay a set amount – the face or par value – of the bond in the future. For example, a government may issue a bond that will pay the bearer $100 in five years. You will gain no interest return if you pay $100 for that bond today. If you only pay $90, though, you will earn $10 of interest when the bond matures in five years. If the price of the bond drops and you only have to pay $80 for it, you will gain $20 in interest. However, if the bond price rises to $95, you will only receive $5 of interest when it matures. So the price of the bond and the amount you earn in interest, the effective interest rate, move in opposite directions.
Paul Mueller is a Senior Research Fellow at the American Institute for Economic Research. Dr. Mueller also owns and runs a bed and breakfast in the mountains of Colorado with his wife and five children.