From Earth to Heaven: The Changing Drivers of Monetary Policy

Why It Matters

The shift creates tougher trade‑offs for monetary policy and may render standard New‑Keynesian models inaccurate, prompting central banks to redesign reaction functions and communication strategies.

Key Takeaways

• Global shocks now explain ~50% of interest‑rate variance.
• Supply component dominates global shocks, unlike domestic shocks.
• Global shocks are more volatile and persistent than domestic.
• They drive rate‑tightening more than easing cycles.
• Central banks must adapt models for asymmetric, persistent global shocks.

Pulse Analysis

The past two decades have upended the textbook view that domestic demand fluctuations dominate business cycles in advanced economies. While the Great Moderation allowed policymakers to rely on the ‘divine coincidence’—stabilising inflation and output with a single instrument—repeated external disturbances such as the 2008 financial crisis, oil price spikes, pandemic‑induced supply bottlenecks and heightened geopolitical risk have injected a new source of volatility. The recent Forbes, Ha and Kose (2026) analysis quantifies this transition, showing that global shocks now explain roughly 50 % of the variance in policy interest rates, a share that rivals domestic influences for the first time since the late 1990s.

Beyond sheer magnitude, global shocks differ qualitatively from their domestic counterparts. The study reveals a larger supply component—especially oil‑price driven disturbances—within the global shock basket, while domestic shocks remain demand‑heavy. Moreover, global shocks exhibit higher standard‑deviation volatility and persist for three years or more in inflation dynamics, compared with the one‑year decay typical of domestic events. This asymmetry translates into a pronounced bias toward monetary tightening: global shocks contribute more to rate hikes than to cuts, forcing central banks to react more aggressively to external pressures.

These empirical insights call for a recalibration of the policy toolkit. Standard New‑Keynesian models, which assume symmetric, temporary shocks, may under‑estimate the inflationary drag of persistent global supply disruptions and over‑state the effectiveness of ‘looking through’ them. Central banks should incorporate scenario‑based forecasting that captures the higher volatility and longer horizons of global shocks, and consider revising reaction functions to allow for asymmetric responses. As climate change, trade fragmentation and geopolitical tensions continue to generate unpredictable external forces, adapting frameworks now will improve credibility and reduce the risk of policy missteps.