The tightrope: fighting inflation without breaking growth
Since 2021, central banks have been walking a narrow tightrope: bring inflation back under control without tipping economies into recession. It is a high-stakes exercise. Move too slowly, and prices spiral. Move too fast, and businesses, households and governments face a brutal credit crunch.
From Washington to Frankfurt, London to São Paulo, the same question dominates monetary policy meetings: how far can we tighten before something breaks?
This article looks at how major central banks are navigating this dilemma, what they have learned from past crises, and what this balancing act means in practice for companies, investors and policymakers.
From “transitory” to persistent: how we got here
To understand current strategies, we need to rewind the tape.
Between 2020 and 2021, three major shocks piled up:
- Pandemic disruption: lockdowns broke supply chains, from semiconductors to shipping, pushing production costs and delivery times sharply higher.
- Massive fiscal and monetary support: governments injected trillions into the economy, while central banks cut rates to zero (or below) and bought government and corporate bonds on an unprecedented scale.
- Energy and geopolitical shocks: Russia’s invasion of Ukraine in 2022 sent gas and oil prices soaring, especially in Europe, while food prices spiked in many emerging markets.
Initially, several central banks – notably the Federal Reserve (Fed) and the European Central Bank (ECB) – described the inflation surge as “transitory”. The assumption: once supply chains normalised and energy prices fell, inflation would too.
That diagnosis proved too optimistic. By 2022, inflation had become broad-based, spreading from energy and goods to services and wages. In the US, headline inflation exceeded 9% in June 2022, the highest in four decades. In the euro area, it peaked above 10% in October 2022. Central banks had to slam on the brakes.
Fastest tightening cycle in decades – and yet no global crash (so far)
Once convinced that inflation was no longer temporary, central banks moved quickly. The scale of tightening since early 2022 is unprecedented in the post-2008 era.
By late 2024, the picture looked roughly like this:
- US Federal Reserve: policy rate lifted from near 0% in early 2022 to a peak above 5%, the fastest hiking cycle since the 1980s.
- European Central Bank: from -0.5% in mid-2022 to levels above 4% within a little over a year – the end of the negative rate era.
- Bank of England: from 0.1% in late 2021 to above 5% by 2023, in response to inflation that exceeded 11% at its peak.
- Emerging markets: many central banks, including Brazil, Mexico and parts of Eastern Europe, started hiking earlier, often in 2021, to stabilise currencies and anchor expectations.
Under normal circumstances, such an aggressive tightening would almost guarantee a recession. Yet, by 2024, several advanced economies had slowed significantly but avoided deep contractions. Growth was weak, but not catastrophic. Labour markets remained surprisingly resilient, with unemployment at or near historic lows in the US and still contained in the euro area.
How did central banks manage to hit the brakes this hard without triggering a global pile-up?
Three levers central banks are using more carefully than in the past
What has changed is not the basic toolkit – still interest rates, balance sheets and communication – but the way central banks combine and calibrate these tools.
1. Interest rates as the main signalling instrument
Policy rates remain the primary weapon against inflation. However, central banks have learned several lessons from earlier episodes:
- Move off zero rapidly: leaving rates at rock-bottom levels while inflation surges can unanchor expectations. Hence the sharp 50 and 75 basis point hikes in 2022–2023.
- Then slow the pace: once rates reach “restrictive” territory, smaller, more gradual moves help avoid over-tightening and allow time to assess the lagged impact on the real economy.
- Focus on the destination, not each step: markets care less about a single hike than about the final level and the time spent there. That is why central banks now emphasise how “long” rates will stay elevated.
2. Balance sheet tools used as a secondary brake
After years of quantitative easing (QE) – large-scale bond purchases – central banks are moving towards quantitative tightening (QT): allowing bonds to mature or, in some cases, selling them.
The logic is straightforward: by shrinking their balance sheets, central banks gently push up long-term interest rates, without having to raise short-term rates even higher.
Two important nuances:
- QT is mostly passive: in the US and the euro area, central banks mainly let bonds mature rather than selling aggressively, avoiding sudden market stress.
- Balance sheet runoff can be paused: if financial conditions tighten too abruptly (for example, due to a banking scare), central banks can slow QT without touching policy rates.
This dual approach gives them more flexibility than in previous cycles, when rates were almost the only game in town.
3. Forward guidance to manage expectations, not to lock themselves in
Before the pandemic, central banks often gave very precise “forward guidance”, promising to keep rates low for a specified period. That helped during the low-inflation era, but it became a constraint when conditions changed rapidly.
Recent practice is more cautious:
- Conditional guidance: central banks now repeat that decisions are “data-dependent”, to avoid being trapped by previous statements.
- Scenario-based communication: instead of a single narrative, they present alternative paths (“if inflation surprises on the upside, we may have to do more…”).
- Less calendar, more indicators: the focus has shifted from specific dates to explicit criteria: inflation trajectories, wage dynamics, unemployment and credit conditions.
The goal is to steer expectations without issuing promises that may become obsolete within months.
Why we have not seen mass unemployment (yet)
A key surprise for many observers has been the resilience of labour markets despite aggressive tightening. Several mechanisms explain this relative strength.
Post-Covid labour shortages
In many advanced economies, demographic trends (ageing populations) and changes in worker preferences (early retirement, sectoral shifts) created structural labour shortages after the pandemic. Companies that struggled to hire in 2021–2022 are now reluctant to lay off staff at the first sign of slowdown, for fear of being unable to rehire later.
Corporate balance sheets in better shape
Thanks to years of ultra-low interest rates and government support programmes during Covid, many companies entered the tightening cycle with stronger balance sheets and large cash buffers. This has allowed them to absorb higher borrowing costs for longer, delaying drastic cuts in investment or employment.
Targeted fiscal measures cushioning households
In Europe, for example, governments deployed energy subsidies, price caps or one-off payments to protect household purchasing power from the energy shock. These measures softened the blow of higher prices and higher rates, supporting consumption and therefore growth.
In other words, monetary policy has been restrictive, but not operating in a vacuum. Fiscal authorities have partially offset the shock, reducing the risk of a deep recession – at the cost of higher public debt.
The hidden risks: financial stability and “shadow” tightening
Even if GDP numbers remain positive, the real economy is not the only area of concern. Central banks must also watch for financial accidents.
Banking sector stress as an early warning
In March 2023, the failures of Silicon Valley Bank and Signature Bank in the US, and the emergency rescue of Credit Suisse in Europe, showed how quickly higher rates can expose vulnerabilities:
- Banks that hold large portfolios of long-term, low-yield bonds face heavy unrealised losses when rates rise.
- If depositors lose confidence, withdrawals can accelerate before banks can adjust their balance sheets.
The response from central banks was telling. The Fed, for instance, continued its anti-inflation stance with high rates, but simultaneously created emergency lending facilities to provide liquidity to banks under stress. Message to markets: we will fight inflation, but we will also backstop the system if necessary.
“Shadow” tightening through credit conditions
Another dimension often overlooked in public debate is the tightening of credit standards. Even if policy rates remain stable for a few meetings, banks can:
- Raise lending margins above policy rates.
- Tighten collateral requirements.
- Reduce exposure to riskier sectors (startups, commercial real estate, highly leveraged firms).
Central banks monitor lending surveys and credit growth closely. If banks become too cautious, the effective tightening becomes much stronger than what the headline policy rate suggests. In such a scenario, central banks may decide to pause or slow QT even if inflation has not fully returned to target.
Different regions, different constraints
Not all central banks face the same dilemma. The global economy is fragmented, and the margin for manoeuvre varies significantly.
United States: testing how long “higher for longer” can last
The Fed has more room to act than most peers:
- The US dollar remains the world’s reserve currency, reducing the risk of capital flight.
- The labour market has been exceptionally strong, with unemployment near multi-decade lows.
- Fiscal policy, while controversial, has been supportive through large investment programmes (infrastructure, green technologies, semiconductors).
This combination allows the Fed to keep rates high for longer to crush inflation expectations, even at the cost of slightly weaker growth. The main risk lies in highly leveraged sectors (commercial real estate, some tech or private equity segments) and in the sustainability of public debt in an era of higher rates.
Euro area: juggling inflation, fragmentation and energy
The ECB operates in a different environment:
- Energy shocks hit Europe harder, especially countries dependent on Russian gas.
- Productivity and potential growth are lower than in the US, limiting tolerance for tight policy.
- Public debt levels vary widely between member states, raising fears of renewed bond market fragmentation.
To manage this, the ECB has adopted a two-tier approach: relatively aggressive hikes to restore price stability, combined with instruments designed to prevent a eurozone debt crisis (for example, tools to intervene if spreads between sovereign bonds widen excessively).
The political dimension is also more visible: high interest rates fuel debates about social inequalities, industrial competitiveness, and the pace of the green transition.
Emerging markets: early movers, but vulnerable to global shocks
Many emerging market central banks were actually ahead of the curve. Brazil started raising rates in early 2021, well before the Fed, taking its policy rate from 2% to above 13% in about a year and a half. The goal was clear: stabilise the currency and prevent imported inflation.
Their constraints are different:
- Excessive rate differentials with advanced economies can trigger capital outflows and currency depreciation.
- Food and energy represent a larger share of consumption baskets, making inflation socially and politically explosive.
- Debt is often denominated in foreign currency, amplifying the impact of global financial conditions.
In this context, some emerging markets have started cautiously cutting rates earlier than advanced economies, hoping inflation will remain under control. Their room for error is narrower: a misstep can quickly translate into currency crises or balance of payments stress.
What businesses and investors are watching
For companies and investors, the central banks’ balancing act is not a theoretical debate. It shapes financing costs, investment decisions and risk management strategies.
Key questions in boardrooms and investment committees include:
- How persistent will core inflation be once energy effects fade?
- At what level will policy rates stabilise in the medium term – back near zero, or structurally higher than in the 2010s?
- Which sectors are most exposed to refinancing shocks (real estate, private credit, leveraged buyouts)?
- How will wage dynamics and labour shortages affect margins over the next 2–3 years?
Practical adjustments already underway
- Debt management: many firms are accelerating refinancing to lock in current rates before potential further tightening, or conversely waiting for an expected easing cycle if they can afford it.
- Investment criteria: hurdle rates for projects are rising. Investments that were profitable with money at 0% are no longer viable with capital at 5–6%.
- Pricing strategies: companies in sectors with stronger pricing power (branded consumer goods, specialised B2B services) are testing how far they can pass on higher costs without destroying demand.
- Scenario planning: CFOs and treasurers are running multiple macro scenarios (soft landing, mild recession, renewed inflation shock) to stress-test liquidity and capital structure.
What’s next for central banks?
Looking ahead, central banks face three simultaneous challenges.
1. Assessing the “new normal” for interest rates
The pre-Covid decade was marked by near-zero or negative rates and chronic undershooting of inflation targets. That era appears to be over. Structural forces – deglobalisation, the energy transition, ageing populations, higher defence spending – all point towards:
- More frequent supply shocks.
- Higher investment needs (infrastructure, climate, technology).
- Potentially higher equilibrium interest rates than in the 2010s.
Central banks must therefore determine where the new “neutral” rate lies – high enough to anchor inflation, but not so high as to choke off productive investment.
2. Coordinating implicitly with fiscal policy without losing independence
Monetary and fiscal policies have been pulling in different directions in some countries: central banks tightening to fight inflation, governments spending to cushion households and finance strategic priorities. The risk is that if fiscal policy remains too expansionary, monetary policy has to stay tighter for longer.
While formal coordination is limited (to preserve central bank independence), implicit dialogue is intensifying. The message from many central banks is clear: sustainable public finances are now a key condition for price stability.
3. Preserving credibility in a more volatile world
Credibility is the central banks’ most valuable asset. It is what allows them to influence inflation expectations – and therefore wage and price-setting – with words as much as with interest rates.
After misjudging the persistence of inflation in 2021, several institutions are now under greater scrutiny from markets, politicians and the public. Rebuilding and maintaining trust requires:
- Transparent communication about uncertainties and trade-offs.
- Clear acknowledgement of past errors and lessons learned.
- Consistent alignment between rhetoric and actual decisions.
In a world of recurring shocks, from geopolitics to climate and technology, central banks will rarely enjoy ideal conditions. Their task is less about engineering perfect outcomes than about avoiding the worst combinations: runaway inflation on one side, and deep, prolonged recessions on the other.
For businesses, investors and policymakers, the message is straightforward: the era of “free money” is behind us, but so is the complacency about inflation. Navigating this new landscape requires the same mindset central banks are trying to adopt – realistic about constraints, agile in execution, and ready to adjust course as data and shocks evolve.