When global shocks took over
Kristin Forbes, Jongrim Ha, and M. Ayhan Kose provide a systematic, cross-country analysis of how the balance between global and domestic shocks driving monetary policy has shifted over the past 55 years.
The authors build a country-specific FAVAR (Factor-Augmented VAR) model estimated on monthly data from 1970 to 2024 for 13 advanced economies (including the G-5: US, euro area, UK, Canada, Japan). Their model includes 7 structural shocks, split into: 4 global shocks and 3 domestic shocks.
Findings
- The rising dominance of global shocks: The share of interest rate variation explained by global shocks more than doubled from 1970–1998 to 1999–2019, and more than tripled by 2020–2024, reaching roughly half of all variation on average and as high as 89% for the euro area in 2020–2024.
- Global shocks are supply-heavy: Over 1999–2019, supply shocks account for 34% of global shock contributions to interest rate variation, versus only 14% for domestic shocks. Domestic shocks are predominantly demand-driven.
- Global shocks are more volatile and larger: Global shocks exhibit higher variance than domestic shocks in 12 of 13 economies over 1999–2019. Large shocks (>1 standard deviation) occur more frequently when of global origin. Domestic shock volatility has actually decreased over time, while global shock volatility has increased.
- Global shocks are far more persistent: The inflationary impact of domestic shocks typically dissipates within a year, on the other hand the effects of global shocks persist for more than three years for all shock types (demand, supply, and monetary policy).
- Global shocks drive tightening, not easing: Global shocks explain 58% of interest rate variation during tightening phases but only 47% during easing phases. Crucially, global monetary policy shocks barely contribute to rate cuts, but play a significant role in rate hikes. Domestic monetary policy shocks do the opposite as they are the primary driver of easing cycles.
- Central banks are no longer “looking through” global supply shocks: Since 1999, global supply shocks explain a larger share of interest rate variation than of inflation or output variation i.e. the opposite of what optimal “look through” theory would predict. This pattern has strengthened since 2020.
- The Euro area is the most exposed: Among G-5 economies, the euro area is the most exposed to global shocks in every period, consistent with its deep trade and financial integration. By 2020–2024, global shocks explained 89% of euro area interest rate variation.
Heaven or Earth? The Evolving Role of Global Shocks for Domestic Monetary Policy
Authors: Kristin Forbes, Jongrim Ha, M. Ayhan Kose
From: MIT Sloan School of Management, World Bank
Reading the Fed and the ECB: market perceptions in the post-pandemic cycle
Forbes et al. above, show that central banks have stopped looking through global supply shocks, thise paper by Luca Baldo and Marco Bernardini shows that financial markets have perceived and priced in exactly this behavioral shift in real time. The authors construct a novel daily market-based measure of revisions in near-term policy rate expectations for both the ECB and the Fed, derived from overnight index swap (OIS) contracts linked to monetary policy meeting dates. These swaps capture only unexpected changes in the expected rate path i.e., genuine daily revisions rather than moves along a known path.
These daily revision series are embedded in a two-country Bayesian VAR (BVAR) model with six endogenous variables: policy rate revisions, 1y-1y inflation swap rates, and equity indices (EUROSTOXX and S&P 500) for both the euro area and the US. The estimation sample runs from February 2022 to December 2024, exploiting the exceptional volatility of the post-pandemic tightening cycle. The results are benchmarked against the pre-ELB period (2006–2008) to isolate what changed.
Findings
- Markets perceived both central banks as more responsive to inflation, regardless of shock source. During the post-pandemic cycle, markets anticipated a larger policy rate response to a given increase in expected inflation, both when inflation was demand-driven and when it was supply-driven, compared to the pre-ELB period. This is the market-side confirmation of Forbes et al.’s finding that central banks stopped “looking through” global supply shocks.
- Supply shocks were treated nearly on par with demand shocks. Before the ELB period, markets expected central banks to respond 2 to 3 times more aggressively to demand-driven inflation than to supply-driven inflation, consistent with the classic “look through” framework. During 2022–2024, this ratio collapsed to just 1.2 times. In short, markets stopped expecting central banks to look through supply shocks.
- US supply shocks became a new source of cross-border spillovers to ECB rate expectations. Before the ELB period, only US demand shocks generated meaningful spillovers to ECB rate expectations; US supply shocks had virtually no cross-border effect. During the post-pandemic cycle, US supply shocks became equally important as demand shocks in driving revisions to ECB rate expectations. A 1% revision in expected Fed rates translated into a 0.5% revision in expected ECB rates on average.
- US shocks account for 40% of ECB rate expectation revisions. The historical decomposition shows that foreign (US) shocks explained roughly 40% of the volatility in ECB rate expectation revisions during 2022–2024, versus only 10% of Fed rate variation explained by euro area shocks.
- Supply shocks drove the 2022 tightening; demand shocks sustained it in 2023–2024. Breaking down the sample: supply shocks (energy prices after Russia’s invasion of Ukraine) dominated upward rate revisions in 2022; demand dynamics took over in 2023–2024, with US demand spillovers keeping ECB expectations elevated even as domestic euro area conditions weakened.
What drives policy rate expectations? Evidence from the post-pandemic monetary policy cycle
Authors: Luca Baldo, Marco Bernardini
From: Banca d’Italia
