Why inflation keeps central banks busy.
By the OFX team | 15 April 2026 | 4 minute read
The perennial challenge of inflation is back in focus, with persistent cost pressures across major economies already testing central banks’ toolkits – and resolve – even before the re-emergence of a large-scale energy shock in 2026.
The escalation of conflict in the Middle East has disrupted a significant share of global oil and gas supply; and, given the modern economies’ reliance on refined liquid-fuel products and fertiliser, the consequent price shocks are accelerating inflation broadly. This is a situation that has played out many times. Historically, oil price shocks have often preceded a recession, usually because the associated inflation often triggers central banks to raise interest rates.
This is the conundrum for central banks. Most have inflation as a priority concern, with many operating an inflation targeting regime, whether explicitly or implicitly.
Central banks inflation targeting framework explained.
Most central banks operate under mandates that prioritise price stability, often through formal or informal inflation-targeting frameworks. These frameworks typically aim to keep inflation within a defined range over time, while allowing for short-term fluctuations to support economic growth and stability.
In Australia, for example, the Reserve Bank of Australia (RBA) runs a “flexible” inflation targeting regime, initiated in the early 1990s, with the goal of keeping consumer price inflation (CPI) between 2% and 3% in the medium term. This framework aims to achieve price stability while allowing for short-term variation to support economic growth and employment. The RBA considers that maintaining inflation within this range preserves the purchasing power of Australians’ money and encourages sustainable growth in the economy.
Operatinges under a charter aiming to balance not only for price stability (that is, the 2%–3% inflation target range) and but also for ‘full employment,’ to ensure long-term economic welfare. The employment goal is defined as “maximum employment that is sustainable and consistent with low inflation.”
Central banks don’t just watch CPI: its preferred measure is the “trimmed mean” CPI, a measure of underlying inflation that calculates the weighted average of the central 70% of price changes, excluding the 15% highest and 15% lowest movers.
The CPI inflation figure is the essential component of the ‘feedback loop’ between inflation and central bank policy, which is a dynamic cycle where high inflation prompts the central bank to raise interest rates, reducing economic activity and demand, to constrain price growth. By engineering a slowing of economic demand, central banks aim to bring current inflation under control and to reduce future inflation. Conversely, by lowing interest rates when inflation reduces towards its target range, economic growth slows or unemployment rises. In cutting rates, the aim is to stimulate economic activity by encouraging borrowing, reducing mortgage repayments and lowering the cost of living.
Understanding the inflation–interest rate feedback loop.
The feedback loop is more accurately described as a ‘negative feedback loop’ when central bank interest rate hikes – intended to dampen inflation – actually exacerbate cost-of-living pressures, potentially causing excessive economic contraction. While rate rises are meant to cool demand, they increase mortgage repayments, which, if high enough, can boost inflation-related, debt-servicing costs and slow the economy too fast.
This is where ‘flexible’ targeting regime comes into play: the central bank acknowledges that too aggressive a response to inflation could cause an unnecessarily harsh slowdown of the economy. It has to find a middle ground between that risk and keeping inflation under control with monetary policy (that is, the management of interest rates and money supply.)
Whether a central bank uses a strict point target or a flexible range, the process remains similar: interest rates influence financial conditions, which in turn shape economic activity and inflation outcomes.
To use the Reserve bank of Australia as an example: in the past four years, the RBA has adjusted interest rates 18 times, changing from a hiking cycle to a cutting cycle, and back again to hikes. Australia’s inflation rate has shown significant volatility recently, peaking around 6.6%–7.3% in 2022–2023 following the COVID pandemic, before cooling to an estimated 3.2%–3.7% in early 2026, driven largely by housing and food costs.
To manage these complexities, central banks increasingly emphasise a forward-looking and flexible approach. Policymakers assess a wide range of indicators, including underlying inflation measures, wage growth, labour market conditions, and global developments, rather than relying solely on headline inflation data. Communication also plays a critical role in shaping expectations: by signalling their policy intentions, central banks aim to anchor inflation expectations, which can influence wage-setting and pricing behaviour.
Ultimately, the effectiveness of the feedback loop depends not just on the level of interest rates, but on how households, businesses, and financial markets respond to both current policy settings and anticipated future actions.
With the ongoing US/Iran conflict adding energy price complexity, central banks face a very big decision at the next monetary policy meeting.
References.
1. https://www.commbank.com.au/articles/newsroom/2026/03/march-rba-minutes.html
