For three decades, modern central banking was guided by one monetary policy regime, which has been uniformly adopted by the most influential monetary authorities, including the

Reserve Bank of New Zealand (pioneer), the US Federal Reserve, the European Central Bank,

and the Bank of England. The theoretical foundation for adopting the flexible inflation targeting regime was informed by one core belief concerning the driving forces of modern macroeconomics. Specifically, monetary policymakers assumed that demand was the key endogenous driver of economic cycles. In other words, the monetary policy had no conflicts between its goals of ensuring price stability and maintaining output stability in the face of aggregate nominal demand. As such, when demand-pull pressures emerged and threatened to push inflation above the target level, the central banks would respond by increasing the policy rate, which would slow down the domestic demand growth, thus curtailing inflationary pressures and returning the economy to potential output.

However, as we enter 2026, the macroeconomic environment is no longer dominated by demand volatility, which was accommodated by a flexible monetary policy response. Instead, monetary authorities now operate under persistent supply-driven pressures, which create challenging policy trade-offs between price stability and output stability. First, the world is witnessing a new era of persistent supply shocks of various origins. Second, the macroeconomic impact of supply shocks is far more persistent than was the case throughout the 2000s and 2010s. As such, the central banks are now forced to make painful choices between tolerating higher inflation and allowing the domestic economy to enter a recession.

The Collapse of the Divine Coincidence

In theory, central banks always operated under the divine coincidence – a situation where policies that restore inflation parity also stabilize the economy’s output. The logic was based on the fact that monetary policymakers targeted inflation, not output. As such, when a supply shock drove prices upward, the central bank would increase the policy rate – thus contracting domestic demand and moving the economy back to the long-run output trend. Specifically, policymakers relied on the fact that demand and supply interact to ensure that there is a natural inflation rate compatible with full employment. In other words, when the domestic demand exceeded potential output, wages and prices rose to erode some of the purchasing power of consumers and businesses, thus cooling down the economy. By intervening in the economy through increasing the policy interest rate, the central bank was able to achieve the same goal, except in a shorter period – within one business cycle.

However, once the macroeconomic environment is dominated by persistent supply-side disruptions, the divine coincidence disappears, creating a policy trilemma. In the face of a supply shock, central banks can either do nothing and let inflation surge and hurt domestic output or intervene and smother the economy through higher borrowing costs. The reason why the latter option is no longer viable is highlighted by the fact that monetary policymakers cannot remove supply constraints – they can only affect demand. In other words, the central bank can counter a supply shock by increasing the policy rate, thus cooling down the domestic demand, but doing so will cause the recession – a situation where the domestic demand falls below the potential output.

The Structural Sources of Persistent Cost-Push Volatility

As can be seen, the main challenge facing central banks in 2026 is based on the growing list of persistent supply shocks that fuel cost-push inflation. First, it appears that the era of hyper-globalization is over, and firms are now shifting towards nearshoring and friendshoring, which involves significantly higher production costs. Second, the impact of climate change and water scarcity is increasingly influencing global trade and the prices of various industrial goods and services. Finally, the capital costs associated with the energy transition create additional headwinds for firms that still rely on traditional sources of energy.

Strategic Policy Options

It is noteworthy that central banks fully understand the challenges created by persistent supply shocks, and policymakers are now considering a number of strategic policy shifts, which would allow them to achieve their goals of ensuring price stability while avoiding painful recessions that prevent the domestic economy from operating at its potential.

Policy Core Operational Primary Structural Risk & Framework Mechanics Macroeconomic Vulnerability

Advantage

Strict Uncompromising Maximum Induces severe Point-Target policy tightening to institutional output contractions Framework return CPI to a fixed credibility; firmly and employment

benchmark (e.g., anchors long-term losses when 2.0%). inflation absorbing expectations. exogenous cost shocks.

Inflation Establishing Grants operational Risks gradual drift Target permissible target flexibility to look toward the upper Bands corridors (e.g., 1.5% through temporary boundary if

to 3.5%) rather than supply spikes repeated supply a point target. without rate shocks. shocks occur sequentially. Targeting Excluding volatile Isolates policy Ignores essential Core / components like decisions from living expenses, Supercore energy, food, and exogenous shocks risking loss of Inflation import tariffs from outside central bank public trust and

the target basket. control. misjudging wage pressures.

Framework Formally Reduces financial Requires high Guidance & communicating market volatility communication Look-Throug state-contingent while clarifying the clarity; risks losing h horizons over which central bank's effectiveness if

inflation returns to reaction function. second-round target. effects emerge.

Inflation Expectations and Second-Round Propagation

In an environment of multiple supply shocks, the ultimate central banking battle is fought on the battlefield of inflation expectations. The biggest danger from the first-round supply shock is not the price level increase itself (which monetary policy cannot prevent) but the second-round effects. Whether a supply-driven price shock will have significant second-round effects depends on whether the market participants and businesses believe that inflation is a prolonged phenomenon that will require compensation through higher wages and prices. If people and companies believe inflation to be transitory, then the monetary policy makers can look through it. This means that workers will not demand wage increases that would compensate them for the loss of purchasing power, and companies will not build inflationary general price level increases into their pricing schemes. The initial price increases will simply dissipate once the supply constraints are resolved. However, if multiple supply shocks lead to persistent inflation, then the worker and manager expectations will shift, leading to second-round increases. Once inflation expectations unhinge, the automatic increases in wages and prices will take place. Central banks will have to embark on a brutal tightening cycle to offset them, even if it means sacrificing economic output.

Outlook

The era of frictionless inflation targeting is over. The combination of the favorable global demographics and cheap energy has ended. In 2026 central banks can no longer take a helicopter view of the price level and simply look through cost shocks. In a world of continuous supply-side reconfigurations, they need to take a more nuanced approach to inflation targeting to balance short-term and long-term challenges. Monetary policy alone cannot offset persistent supply deficits. The ability to maintain price stability in volatile uncertain environment will require an increasing degree of fiscal coordination, including the commitment to build physical resilience into the global economic system.

Sources & Citations

  • "One Global Shock, Many Inflation Paths: Inflation Propagation in a World of Repeated Supply Shocks," SUERF Policy Note (No. 412, July 2026).
  • "Monetary Policy in a World of Overlapping Shocks," European Central Bank Speeches & Policy Papers (September 2026).
  • "Supply Shocks and Demand Signal Blurring for Monetary Policy," PIMCO Macroeconomic Insights (May 2026).
  • "The Central Bank's Dilemma: Look Through Supply Shocks or Control Inflation Expectations?," International Monetary Fund (IMF) Working Papers (WP/26/97, May 2026).
  • "Supply Shocks, Inflation Persistence, and Framework Guidance," Journal of Monetary Economics (Vol. 156, Issue 3, August 2026).