Central Banking in an Age of Global Supply Shocks

Şebnem Kalemli-Özcan

TOKYO—As G7 finance ministers were meeting in Paris this month, the bond market was telling us what their official communiqués would not. The 30-year US Treasury yield touched 5.2% on May 19—the highest rate since 2007—while Germany’s 10-year Bund hit a 15-year high and the 30-year Japanese government bond set a fresh record of its own.

These movements came after the US Federal Reserve decided, in April, to hold rates at 3.5–3.75%, with the Federal Open Market Committee more divided than it has been in three decades. 

Across the Atlantic, markets put the odds of a European Central Bank rate hike by December at 85%. After five years of being told that inflation was transitory, then conquered, then transitory again, investors have concluded otherwise.

Monetary policy is operating in a new environment, under conditions that are fundamentally different from those in which modern inflation targeting was designed. 

The orthodox framework was built for a world in which most macroeconomic shocks affected demand, aggregate or sectoral supply disruptions were small enough to “look through,” and central banks could rely on a stable Phillips curve linking aggregate labor-market slack to weaker inflation. Unfortunately, none of those assumptions are fit for a geopolitically fragmented world characterized by frequent supply shocks.

Consider the COVID-19 experience. In a June 2022 presentation for the ECB Forum on Central Banking, my co-authors and I examined inflation in terms of aggregate demand, sectoral demand, and sectoral supply shocks. 

The result that surprised most readers—though it should not have—was that over two-thirds of eurozone inflation between late 2019 and late 2021 originated outside the eurozone, having been transmitted through global production networks.

Supply-side disruptions in foreign sectors, propagated by input-output linkages and amplified by the consumption shift from services to goods, accounted for the bulk of the price pressure. Domestic aggregate demand mattered, but not nearly as much as the policy debate assumed. The interaction between aggregate demand and sectoral supply shocks was more relevant.

In a scenario where supply is constrained, the global production network is granular (meaning it comprises many firms of different sizes spread across many sectors and locations), and demand is elevated via fiscal or monetary stimulus or booming stock markets, more inflation is produced than in a non-supply-constrained economy. 

Policies to manage aggregate demand cannot eliminate distortions in global networks, because monetary policy is a national instrument. As the inflation-output trade-off worsens, achieving disinflation becomes more expensive.

During the 2022–24 disinflation episode, the Fed hiked the benchmark federal funds rate 525 basis points in 16 months, going faster and further than any G7 peer, and US inflation duly fell from a peak of 9.1% in June 2022 to roughly 3% by mid-2023. 

Because the ECB was slower to start tightening and constrained by a weaker recovery and an energy shock (linked to the Russian invasion of Ukraine) it could not control, eurozone disinflation took longer. And in the United Kingdom, which faced the greatest energy-passthrough pressure, the process took longer still.

Conventional narratives credit these differences in the speed of disinflation to differences in the underlying inflation mix. But that is not the whole story. The more important factor was central-bank credibility. Long-run inflation expectations in the US barely moved off 2% because the Fed convinced markets that it would do whatever was necessary.

Credibility, in other words, did most of the heavy lifting. The actual rate hikes mattered less than the market’s belief that more would come if needed. There is only one mechanism whereby monetary policy can stabilize supply-side inflation cheaply: by ensuring that no one will bother to price in a wage-price spiral, because everyone knows that the central bank would never tolerate one.

That is why the current configuration is so much more difficult than the last one. In 2022, central banks faced two supply shocks—the pandemic and Russia’s full-scale invasion of Ukraine. In 2026, they face a sequence that came on top of these previous shocks: tariffs followed by the Iran war. 

The US government’s attacks on central-bank independence thus could not have come at a worse time. Some 62% of fund managers now expect the 30-year Treasury yield to reach 6%, not because they are forecasting Fed incompetence, but because they can see the constraints the Fed is operating under.

We have seen this movie before in emerging markets. In Turkey, sustained political interference in monetary policy pushed inflation from under 20% in 2021 to above 80% in 2022, unleashing a cycle that could be reversed only with extreme measures and significant pain. And Argentina, of course, has been pressing repeat for decades.

The mechanics are always the same. The central bank loses the freedom to react ahead of inflation expectations; it remains behind the curve, and the cost of disinflation rises by an order of magnitude. The point of ensuring that you have a credible central bank is precisely that you do not have to find out how much credibility you have when it really counts.

Bond markets are telling us three things. First, inflation is no longer a discrete problem to be solved at the national level; it is global in nature, reflecting frequent supply shocks in an economically fragmented world. Second, fiscal stimulus in the face of today’s supply shocks is the worst possible response, and one that monetary policy alone cannot offset. And third, central-bank independence is less costly to defend when it is not yet under threat, and more expensive to rebuild after it has been lost.

Markets have seen the writing on the walls. Governments must open their eyes, too.

Şebnem Kalemli-Özcan, Professor of Economics at Brown University and Director of the Global Linkages Lab, is a former senior policy adviser at the International Monetary Fund and former lead economist for the Middle East and North Africa at the World Bank.

Copyright: Project Syndicate, 2026.
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