Central banks should focus on the duration of the global shock and how it is reflected in inflation — study

**Central banks must focus on the duration of global shocks and their reflection in inflation — study**

In a complex macroeconomic environment characterized by heightened global instability and consecutive shocks, central banks must pay special attention to how long a global shock lasts and how it manifests in overall prices and inflation expectations, recommended the Deputy Chief Economist of the World Bank.

In the first edition of the project, Central Bank specialists Bekhruz Akhmedov and Nurbek Omonov, along with project guest Ayhan Kose, discussed the paper "Heaven or Earth: The Evolving Role of Global Shocks for Domestic Monetary Policy," published by the National Bureau of Economic Research and co-authored by Kristin Forbes, Jongrim Ha, and Ayhan Kose.

Bekhruz Akhmedov noted that today central banks around the world are operating in the most complex macroeconomic environment observed in recent decades. According to him, inflationary shocks, geopolitical fragmentation, energy instability, supply chain disruptions, tightening cycles, and financial market stresses are making crucial decision-making increasingly difficult for central banks.

Monetary policy frameworks are also being tested in real-time. For decades, central banking systems were shaped primarily by domestic demand, domestic inflation, and domestic business cycles. But now, monetary policy is increasingly being determined by forces originating beyond national borders. This brings to the agenda the question of whether central banks are still managing their economies based on local context and domestic factors, or if they are limited to responding to global shocks they cannot control.

The Central Bank specialists addressed this very question to Ayhan Kose, Deputy Chief Economist of the World Bank and Director of the Prospects Group, as well as one of the authors of the paper selected for discussion.

At the beginning of his speech, Ayhan Kose dwelt on the origin and meaning of the "Heaven and Earth" metaphor in the title of the paper. According to him, the phrase in the title traces back to a famous military metaphor. In the fifth century BC, Sun Tzu advised generals to equally consider heaven — forces beyond human control — and earth — the battlefield — for victory. According to the authors' interpretation, today central banks face a similar situation: the need to account for the impact of global shocks beyond their control on the domestic economy.

"Heaven basically represents global shocks that central banks cannot control, such as global financial disruptions, oil price fluctuations, supply chain issues, pandemics, and geopolitical tensions. Earth basically represents shocks related to domestic demand, supply, and monetary policy," explains Ayhan Kose.

Kose noted that during the roughly two-decade moderate period from the mid-1980s to the mid-2000s, domestic demand shocks played a major role in driving the economy. Under those conditions, central banks were able to stabilize both inflation and economic activity simultaneously. However, over the past two decades, economies have faced consecutive major global shocks, which has made conducting monetary policy much more complex.

The authors of the study analyze mainly advanced economies in the period from 1970 to 2024 and focus on four global shocks — global demand, global supply, oil prices, and global monetary policy, as well as three domestic shocks — domestic demand, domestic supply, and domestic monetary policy.

"The first key finding of the study is that the importance of global shocks is increasing over time. Until the late 1990s, they explained only a small fraction of interest rate fluctuations. By the period between 1999 and 2019, their contribution increased to more than one-third. And by 2020–2024, almost half of interest rate fluctuations are explained by global shocks. Currently, in a number of major economies, global shocks have become a more important factor than domestic shocks," the specialist explains.

The second important conclusion shows that global shocks differ sharply from domestic shocks.

First, they have a much larger supply component. That is, supply factors play a more important role in the nature of global shocks than demand factors. Domestic shocks, on the other hand, are mainly driven by demand and domestic monetary policy.

Second, the scale of global shocks is larger and their volatility is higher. Their growing impact, apparently, is not related to higher sensitivity of central banks. On the contrary, the frequency and strength of these shocks are increasingly rising, and their consequences are becoming more severe.

Third, global shocks have a much longer-lasting effect on inflation. The inflationary impact of domestic shocks usually dissipates within about a year. Global shocks, however, last much longer, and their impact persists for more than three years.

Fourth, global shocks have an asymmetric character, meaning they affect monetary policy tightening more than easing.

Kose said there is a view that central banks often ignore supply shocks because tightening monetary policy cannot directly resolve a supply problem. However, according to him, in recent years regulators have changed their views on this and begun to respond more strongly to global supply shocks. This is probably due to the fact that the scale and duration of global shocks have increased, strengthening the likelihood of their affecting inflation expectations.

Based on the study's findings, Kose emphasizes that monetary policy models must adapt to the conditions of global shocks and account for their importance, and central banks need to develop their policy frameworks.

"Central banks need to consider to what extent they should react sharply to major global shocks and adjust their frameworks accordingly. Forecasting and communication must also adapt. Global shocks are difficult to predict and often result from geopolitical or non-economic events. Therefore, central banks should focus more on different scenarios instead of relying mainly on a single central forecast when assessing where they are in the business cycle, as well as inflation and economic activity," explains Ayhan Kose.

In response to the question of whether the growing scale and strength of external shocks is related to deepening integration, Ayhan Kose noted that more integration inevitably exposes a country to more external shocks.

"Global shocks have always existed, but over time their volatility and duration have increased, and they have become larger. In turn, their impact on inflation and economic activity has become more pronounced. I think the most important issue is that the framework and ability to control monetary policy exist. There is a clear understanding of how to respond to external and domestic shocks," he explains. "What has changed and become more difficult for central banks is the external environment in which they operate."

This, Kose notes, means that central banks must be faster and more flexible in assessing these shocks, take into account that global shocks can be much stronger than domestic shocks, and respond accordingly within their frameworks.

The World Bank specialist also touched upon how global shocks affect regulatory decisions under an inflation targeting regime. He noted that inflation targeting has served central banks around the world well, providing a clear anchor and direction for curbing price pressures. But now, it too needs to be improved.

"Inflation targeting was developed during a period when domestic demand shocks were dominant. Under such conditions, if you raised interest rates, you could lower both inflation and excess demand. In this sense, decision-making was relatively simple," Kose explains. "But global shocks — supply shocks — are different. They can simultaneously increase inflation and weaken demand and economic activity."

However, according to the study's results, the importance, volatility, and duration of global shocks are increasingly rising. This sharpens the trade-off between price stability and economic activity. Based on this, the inflation target can remain an anchor, but the framework around it must be more flexible in some sense.

According to Kose, regulators in both emerging and advanced economies must now focus not only on whether inflation is high or low, but also on how long the shock lasts and to what extent it is reflected in overall prices and inflation expectations.

"This requires better and more timely data, as well as close monitoring of commodity prices, trade costs, exchange rates, and, of course, global interest rates. And it is advisable for you to have scenario analysis. Instead of just relying on a single baseline forecast, you should have a rich set of scenarios and think about how variations around this baseline forecast could lead to certain outcomes," says Ayhan Kose.

Furthermore, he notes, the main idea is not to respond to every increase in import prices. Some of them are temporary, while others have a different character. But if a persistent, large-scale global shock occurs, or one that threatens inflation expectations in the country, central banks must act more decisively. At the same time, credibility and open communication are crucial — especially during periods of external stress.