How global monetary policy affects the economy

Central banks outside of the U.S., such as the European Central Bank (ECB) and the Bank of England (BOE), have approached interest rate policy more aggressively than the Federal Reserve Bank (Fed). Both the ECB and BOE have cut rates in 2025, while in the first half of 2025 the Fed held off on rate cuts and signaled a “wait and see” approach as the tariff war plays out.

“This time around, we’ve seen a different process for rate cuts,” says Beth Ann Bovino, chief economist at U.S. Bank. “Quite often, it’s the Federal Reserve that gets a jump on rate cuts, setting the stage for other central banks to follow.” In the current rate-cutting cycle, the Fed delayed rate cuts through much of 2024 until implementing three cuts in the year’s closing months. While markets anticipate further rate cuts this year, the Fed has held the federal funds target rate in the 4.25% to 4.50% range.

Businesses and investors closely monitor central bank interest rate policies. The Bank of Japan (BOJ) raised rates recently, but it is coming off rates that were set below 0%.

Central bank policy adjustments

In 2024, monetary policy shifted course in both the U.S. and Europe. The ECB got a jump, initiating interest rate reductions in June 2024. Its main interest rate peaked at 4% in 2023 but now stands at 2.0%. ¹ The BOE raised rates to a top level of 5.25% in 2023. It initiated rate cuts in August 2024, and its bank rate currently stands at 4.25%. ²

Persistent inflationary concerns caused the Fed to delay rate cuts until September 2024. At that time, the fed funds target rate was lowered from a peak of 5.50% in 2023 to the current top level of 4.50%. ³ However, the Fed last cut rates in December 2024. In its first four, 2025 policy meetings, it held the line on interest rates, and Fed Chair Jerome Powell has indicated there’s no rush to lower rates further. Potential inflation ramifications from tariffs are a concern for the Fed, according to Powell. While President Donald Trump has directed intense criticism toward Powell for the Fed’s steadfast 2025 rate stance, Powell cites Trump administration policies as a reason for this. “In effect, we went on hold when we saw the size of tariffs and essentially all inflation forecasts for the United States went up materially as a consequence of the tariffs,” Powell stated recently. ⁴

Unlike the Fed and European banks, the BOJ is raising interest rates from below zero percent to 0.5 percent. ⁵ The BOJ is combating a longstanding challenge of slower economic growth with ongoing inflation risks.

Tariffs create new challenges

Plans to implement larger tariffs on imported goods complicates monetary policy. President Trump is pursuing significant tariffs affecting nearly all trading partners. The Trump administration paused its most stringent tariff plans, but some new tariffs are in effect, and administration officials indicate that by early August 2025, more tariffs are likely to be locked in.

The significant upswing in tariffs creates multiple challenges for central bank policymakers. “U.S. Tariffs usually result in higher prices for imported goods,” says Bovino. “That could lead to a loss of demand for foreign-produced goods.” Bovino says this could slow economic growth in Japan and across Europe. “For the Bank of Japan, that would mean a more measured pace of interest rate adjustments, as higher prices at home may be muted by slowing demand.”

The Fed’s interest rate strategy

Central banks utilize interest rate policy to help achieve key economic goals. For example, the Fed has a dual mandate to promote maximum employment and stable prices. Since the U.S. is the largest economy, Fed policy draws the most attention. “In the current environment, inflation remains a key concern for the Fed,” says Beth Ann Bovino, chief economist at U.S. Bank. She notes that core inflation component of the Consumer Price Index (CPI), which excludes food and energy prices, has held steady at 2.8%. ⁶ The core Personal Consumption Expenditures deflator, the Fed’s preferred inflation measure, stands at 2.7%. ⁷ These figures compare to the Fed’s targeted 2% inflation rate. By contrast, the unemployment rate remains historically low, at 4.1%. ⁶ In recent comments, Fed Chair Powell noted favorable unemployment trends indicate that, “The labor market is not crying out for a rate cut.” ⁸

Balancing inflation and employment goals

Bovino believes the unemployment rate meets economists’ definition of “full employment,” and can arguably be considered at target. “Regarding the Fed’s mandate, the biggest gap between its goal and current data is with inflation rather than the unemployment rate, and that is where the Fed will focus its attention,” says Bovino.

Inflation most recently became a significant concern in 2021 and 2022. By June 2022, the U.S. inflation rate based on CPI topped 9%, its highest level in decades. ⁶ In response, the Fed began an aggressive interest rate-hiking strategy. The Fed sought to slow economic activity to reduce pricing pressures. The Fed’s actions helped significantly temper inflation, close to its 2% target, while avoiding an economic downturn.

The Fed altered its interest rate policy in September 2024 amid signs of labor market weakness. It reduced rates by 1% over four months. Since then, the unemployment rate has remained relatively stable, ranging between 4.0% and 4.2% since early 2024.

Central bankers typically lower interest rates if concerned that the economy may be slowing or tipping into a recession. In 2020, the Fed notably lowered rates from 1.75% to near zero percent at the onset of the COVID-19 pandemic. Similarly, during the financial crisis of 2007-2009, when the economy experienced a significant slowdown, the Fed dropped the fed funds rate from 5.25% to 0.25%.

The different perspective of foreign central banks

Other global central banks primarily focus on maintaining stable prices, without a mandate related to full employment. “Europe has been flirting with recession risk for some time, largely due to the impact of the Russia-Ukraine war,” says Bovino. The war’s onset in February 2022 led to higher energy prices, contributing to slower economic activity. “Unfortunately, the tariff war launched this April only add to Europe’s recession concerns,” says Bovino.

“Japan has been struggling with a long-standing deflationary scenario,” says Bovino. This is due in part to significant demographic challenges with its aging population. Its central bank tried to stimulate economic growth by maintaining its primary interest rate in narrowly negative territory for 17 years. The Bank of Japan raised rates in January to 0.5% from 0.25%, after raising the rate for the first time in 17 years in March 2024. The trade war adds to Japan’s problems and clouds the Bank of Japan’s policy path as the country risks teetering into recession. “The BOJ may attempt another rate hike as core inflation hit a 2-year high,” says Bovino. “Yet given trade tensions, the BOJ may want to also take a wait and see approach if potential U.S. tariffs slow domestic economic activity and impact prices.”

Tariff impact on global monetary strategy

A similar impact could be felt in Europe. “U.S. tariffs could limit demand, reducing European manufacturing activity and slowing its economy,” says Bovino. “If Europe retaliates with tariffs on U.S. goods, it only makes things more expensive for European consumers, adding to inflation concerns.” This creates a potential dilemma for the ECB or BOE, weighing the risk of a recession against another inflation spike.

The U.S. is not immune to such a scenario. “Stagflation may be the biggest risk in a high tariff environment,” warns Bovino. Stagflation combines slower economic growth that results in high unemployment with high inflation. It’s an environment that’s generally been avoided since the early 1980s.

“Tariffs work like a tax, which results in more expensive goods for consumers,” says Bovino. “If other countries boost tariffs, it will create a profit squeeze for U.S. companies, leading to less hiring, higher unemployment, and potentially a stagflation scenario.”

Quantitative tightening strategies

Another tool central banks use is to inject liquidity into markets through a process known as quantitative easing (QE). Central banks purchase assets, such as government bonds, to help keep interest rates down and potentially spur increased lending activity. The Federal Reserve injected trillions of dollars into markets during the 2007-2009 financial crisis, and again in 2020-21 amid the COVID-19 pandemic. Other central banks followed a similar path.

In recent years, as inflation soared, central banks reversed course, applying a quantitative tightening (QT) strategy. The Federal Reserve, for example, carried this out by letting its bond holdings mature and not reinvesting those assets into additional bonds.

Central bank balance sheets remain large, particularly by historic standards. However, the Fed and ECB balances have shrunk considerably from their 2022 peaks. BOE and BOJ balance sheets are little changed in recent months.

Currency calculations in monetary policy

Central bank interest rates play a critical role in determining currency movements. For example, the dollar gained ground against the euro in 2024 and early 2025, as the ECB cut rates more significantly than the Fed. Assets moved into U.S. bonds that offered higher yields than bonds of other markets. As a result, the dollar gained value.

However, the story is far different in 2025, where the dollar has lost considerable ground. “It is likely because of rising imports, which have spiked since the trade war, and a growing trade deficit,” says Bovino. While Bovino notes that recession risk may also explain the dollar’s decline, with other trading partners suffering the same risk, she doesn’t think that’s the main driver. In general, the Fed is less concerned with currency movements, according to Bovino. “However, other countries, particularly those relying on exports as their main economic driver, pay more attention to currency trends.”

Central banks’ influence and critical role

Monetary policy is a constant factor that could significantly impact economic and market trends. Consumers, business owners, and investors pay close attention to actions by the Fed and other central banks and the policy stances they pursue. Interest rate policy and other monetary actions will be implemented to respond to the current economic environment.

While political leaders may often provide input to central bankers, the Fed, ECB, BOE, and BOJ maintain independence. They have full authority to implement policies they believe are most appropriate for the given circumstances.