Central banks steer the economy with monetary policy. They raise or lower interest rates, buy or sell government securities, and adjust reserve requirements. The goal is to keep inflation low, employment high, and the financial system stable. In the United States, the Federal Reserve has a dual mandate: maximum employment and price stability. The European Central Bank targets inflation near 2 percent. The Bank of Japan has pursued aggressive easing for decades.

The main tool is the policy interest rate. When the Fed raises the federal funds rate, borrowing costs rise throughout the economy. Mortgages, car loans, and credit card rates follow. Businesses invest less. Consumers spend less. Inflation cools, but growth slows. When the Fed cuts, the opposite happens. Lower rates stimulate borrowing and spending. The challenge is timing. Move too late, and inflation spirals. Move too early, and the economy stalls.

When rates hit zero, central banks turn to unconventional tools. Quantitative easing buys long-term bonds to push down long-term rates and inject liquidity. Forward guidance communicates future policy intentions to shape expectations. Yield curve control caps long-term rates directly. These tools were used aggressively after 2008 and again in 2020.

Monetary policy is not omnipotent. It cannot fix supply shocks, fiscal deficits, or structural problems. It works with a lag. And its effects are uneven, helping asset owners more than wage earners. The limits of monetary policy are becoming clearer.