Inflation Part 4: Monetary Policy and the Future of Inflation

How monetary policy works

In the first three parts of this series we looked at supply and demand imbalances, globalisation and technology, and how each shapes the path of inflation. The final piece is the institution that sits on top of all three: the central bank.

Central banks such as the US Federal Reserve try to keep inflation stable using two main tools:

1. The policy interest rate. By raising or lowering the overnight rate at which banks lend to one another, the central bank changes the cost of borrowing throughout the economy, from mortgages to corporate loans.
2. The balance sheet. By buying government bonds and other assets (quantitative easing) or letting them run off (quantitative tightening), the central bank adds or removes money from the financial system and influences longer-term interest rates.

Higher rates slow borrowing, spending and hiring, and with them, inflation. Lower rates do the reverse. The effect works with long and variable lags, which is why central banks act on forecasts as much as on current data.

Where these powers came from

For most of the twentieth century, money was tied to gold. Under the Bretton Woods system set up in 1944, other currencies were fixed to the dollar, and the dollar was convertible into gold at USD 35 an ounce. On 15 August 1971, President Nixon closed the gold window, ending that convertibility. From then on, the amount of money in circulation was a policy decision rather than a function of gold reserves.

The reasons go back further, to the Great Depression. As the economy collapsed after 1929, wealth flowed out of productive assets and into safe havens, cash and gold. Prices fell sharply: on the US Bureau of Labor Statistics’ consumer price index, the annual average fell about 24% between 1929 and 1933. Falling prices made cash more valuable simply by being held, and made debts harder to repay, which pushed more capital out of production and deepened the slump. Under a gold standard, central banks had limited ability to break that cycle.

The liquidity trap

This dynamic, later called a “liquidity trap”, describes an economy that stalls because wealth holders prefer to sit in cash rather than fund production, hiring and investment, even when interest rates are very low. Cutting rates further does little, because the problem is not the price of money but the unwillingness to use it.

The modern answer is a central bank that can create money without limit and that commits to positive inflation. If prices are expected to rise gently, cash loses a little value every year, and wealth holders are pushed to invest in productive assets, such as businesses, property and equities, or to lend to those who own them, through bonds. In that sense, inflation is a tax on idle capital, and a deliberate one.

Why 2%, and not zero

In January 2012 the Federal Reserve’s policy committee stated for the first time that inflation of 2% is most consistent over the longer run with its mandate. Most major central banks target a similar figure. The reasoning has three parts:

• A buffer against deflation. A small positive rate keeps the economy further from the self-reinforcing spiral described above.
• Room to cut. Interest rates normally sit above inflation. With a 2% target, the neutral policy rate is higher than it would be at zero, so there is more room to cut in a recession.
• Measurement. Price indices struggle to capture quality improvements fully, so measured inflation may slightly overstate the true rise in the cost of living. A target of exactly zero could mean mild deflation in practice.

Why rates fell for so long, and then did not

For roughly four decades, globalisation and technology held prices down. To keep inflation near target against those forces, central banks ran loose policy for long stretches. The Fed held its policy rate near zero for much of 2009 to 2015 and again from 2020 to 2022, supported by large-scale asset purchases.

The pandemic and the energy shock broke that pattern. US consumer prices rose 9.1% in the twelve months to June 2022, on BLS data, and the Fed raised its target range from near zero to 5.25-5.50% by July 2023. The adjustment has not been one-way since: on 16 September 2026 the Fed raised its range by a quarter point to 3.75-4.00%, stating that “inflation remains elevated.”

Why this matters in the UAE

For anyone saving or borrowing in dirhams, US monetary policy is effectively local policy. The dirham has been pegged at 3.6725 per US dollar since 1997. To keep the peg credible, the Central Bank of the UAE anchors its Base Rate to the Fed’s interest rate on reserve balances. When the Fed raised rates in September 2026, the CBUAE raised its Base Rate from 3.65% to 3.9% with effect from the next day.

Three practical consequences follow:

• Dirham rates follow US conditions, not UAE ones. The UAE imports the Fed’s stance even when its own economy is in a different place in the cycle.
• Local inflation has local drivers. Rents, school fees and domestic fuel prices move on UAE supply and demand, so dirham inflation can diverge from US inflation even as interest rates move together. The Federal Competitiveness and Statistics Centre publishes the UAE consumer price index.
• There is no currency cushion. In a floating-rate economy, a weaker currency can absorb part of a shock. Under the peg, the adjustment falls on prices, rates and activity instead.

Our note on whether to save in AED or USD looks at what the peg means for where cash sits.

Inflation: a look ahead

The forces described in this series now pull in different directions. Technology, including AI and cheaper renewable energy, continues to push the cost of goods and some services down. Deglobalisation, tariffs, supply-chain duplication and the investment required for the energy transition push the other way. Large government deficits in major economies add pressure on long-term rates.

When this series was first written, our view was that the deflationary forces would reassert themselves and rates would eventually fall again. The long-run case for technology as a deflationary force still holds. But the past three years have shown that the path can be slow and uneven, and that central banks will keep policy tight for as long as inflation stays above target. We do not think anyone can forecast that path with confidence, and portfolios should not depend on doing so.

What it means for your portfolio

• Hold cash for liquidity, not storage. Keep enough for known spending and emergencies, in the currency you will spend it in. Beyond that, cash loses purchasing power at any positive inflation rate. Our savings options are built for the liquidity layer.
• Own productive assets for the long run. Equities and real estate have historically been the more reliable long-run protection against inflation, because the businesses and properties behind them can raise prices over time. Our framework on owning real assets explains why. Past performance is not indicative of future results.
• Use bonds deliberately. Bonds provide stability and income, but long-dated bonds lose more value when rates rise. Choosing duration on purpose matters more when the inflation path is uncertain; our fixed income deep dive shows how price sensitivity works.

Understanding the interplay between monetary policy, supply and demand, globalisation and technology will not tell you next year’s inflation rate. It does explain why a diversified portfolio of productive assets, with cash held for a purpose, is the sensible response to all of them.