From earth to heaven: The changing drivers of monetary policy

Business cycles in advanced economies are increasingly driven by global rather than domestic shocks. This column shows that global shocks now account for about half of the variation in interest rates, more than double their role in earlier decades. They also differ systematically from domestic shocks: global shocks have a larger supply component, greater volatility, more persistent effects on inflation, and are more often associated with monetary tightening. Central banks also appear less willing to ‘look through’ global supply shocks than comparable domestic shocks. As global forces increasingly shape domestic outcomes, monetary policy frameworks, models, and communication strategies should evolve accordingly.

In the fifth century BC, Sun Tzu advised generals that victory requires understanding both “heaven”, forces beyond one’s control, and “earth”, the terrain on which battles are fought. More than 2,500 years later, central banks face a similar challenge: understanding how global shocks beyond their control interact with domestic economies. During the Great Moderation from the mid-1980s through the mid-2000s, business cycles in advanced economies were largely driven by domestic demand shocks. In that environment, monetary policy often benefited from the so-called ‘divine coincidence’: monetary policy could stabilise inflation and activity simultaneously, with minimal trade-offs (Bernanke 2004, Blanchard and Galí 2007).

Over the past two decades, however, a sequence of severe global shocks – including the global financial crisis, oil price fluctuations, supply chain disruptions, the pandemic, and rising geopolitical tensions – has generated sharp swings in inflation and output. These shocks have created more difficult policy trade-offs (Tenreyro 2023, Forbes et al. 2025) and reignited debates about how monetary policy should respond (English et al. 2024, Giannone and Primiceri 2024, Forbes et al. 2024).

One issue which has not been a focus of these debates is the importance of understanding whether the shocks originate primarily from “heaven,” that is, global forces beyond national control, or domestic shocks rooted in “earth”. In a new study (Forbese et al. 2026), we examine this issue using a cross-country analysis of advanced economies from 1970 to 2024. To assess how the drivers of monetary policy have evolved, we develop a new factor-augmented VAR (FAVAR) model that decomposes fluctuations in interest rates, inflation, and output growth into seven shocks: four global shocks (covering demand, supply, oil, and monetary policy) and three domestic shocks (covering demand, supply, and monetary policy). The results suggest that global shocks have not only become more important than domestic shocks over time, but they systematically differ across a number of criteria important for monetary policy.

Global shocks are becoming more important…

The role of global shocks in explaining interest rate movements has increased steadily over the last half century. From 1970 to 1998, global shocks played a relatively modest role. Between 1999 and 2019, their contribution more than doubled, accounting for over one third of the variance in interest rates (Figure 1). Over 2020 to 2024, their importance rose further: global shocks now explain about half of the variation in interest rates on average, roughly equal to the contribution of domestic shocks for the first time in the sample. In several major advanced economies, particularly the euro area, the share of global shocks is even larger than that of domestic shocks. In short, “heaven” now explains as much of the variation in interest rates as “earth”.

Figure 1 Contributions of global shocks to the variation in domestic interest rates

Notes: This figure shows the forecast error variance decompositions of domestic policy interest rates (in percent of total variation, averages across 13 advanced economies) over a 40-month horizon based on the FAVAR model developed in Forbes, Ha, and Kose (2026). The model consists of four global variables (output growth, inflation, interest rates, and oil prices) and three domestic variables (output growth, inflation, and interest rates).

… and they have different characteristics

This growing influence of global shocks would matter less for monetary policy if global and domestic shocks had similar characteristics. But they do not. Across multiple dimensions, global shocks differ systematically from domestic shocks – even when excluding the volatile period around the global pandemic.

• Global shocks have a larger supply component. Over 1999 through 2019, supply shocks (including oil prices) accounted for 34% of global shocks, compared with only 14% for domestic shocks (Figure 2). Domestic shocks, by contrast, had a larger monetary policy component, accounting for 38% versus 21% for global shocks. Around the pandemic, the role of supply increased even further for global shocks, with global supply becoming more important than global demand shocks in 2020-2024. This contrasts sharply with domestic shocks, where demand shocks remained two to three times more important than supply shocks throughout the sample.

Figure 2 Contributions of seven shocks to variation in domestic interest rates

Notes: The figures show the share of just the global shocks (left) or share of just the domestic shocks (right), by shock source (in percent, average across 13 advanced economies). The results are based on forecast error variance decompositions of domestic policy interest rates at 40-month horizon based on the FAVAR model, as explained in Figure 1 and Forbes et al. (2026).

• Global shocks exhibit greater volatility. The variance of global shocks exceeded that of domestic shocks over 1999 through 2019 and increased over time, even as the volatility of domestic shocks declined (Figure 3). Global shocks are also more likely to be large (defined as exceeding one standard deviation), especially in recent years. Importantly, the growing role of global shocks in driving interest rates does not reflect greater sensitivity to them. Even after controlling for the source and size, the sensitivity of domestic interest rates to global shocks has generally been lower than to domestic shocks, although the gap narrowed around the pandemic. Instead, the rising influence of global shocks reflects their larger size, greater volatility, and other distinct characteristics.

Figure 3 Shock volatility by source of shock

Note: This figure shows the volatility (standard deviation) of each structural shock (average across 13 advanced economies) over 1999-2019. The shocks are estimated based on the country-specific FAVAR model, as explained in Figure 1 and Forbes et al. (2026). Long-term (1970-2024) volatility is normalized to be one. Global (S) and Global (O) indicate global supply and oil price shocks, respectively.

• Global shocks are more persistent. The impact of domestic shocks on inflation typically dissipates within about a year. In contrast, the effects of global shocks persist for more than three years (Figure 4). This greater persistence holds both in aggregate and when comparing shocks of similar types (e.g. global supply shocks versus domestic supply shocks). In other words, global shocks from each source tend to have longer-lasting inflationary consequences than comparable domestic shocks.

Figure 4 Persistence of shock transmission to inflation

Note: This figure shows the average persistence of the cumulative impulse response (IRF) of domestic inflation following global and domestic shocks over 1999-2019. The shocks are the combinations of different types of global and domestic shocks – i.e., the combination of global demand, supply, oil price, and monetary policy shocks and the combination of domestic demand, supply, and monetary policy shocks, respectively. To compare the persistence of the shock transmission, the IRF at the 6-month horizon is normalized to a positive one percentage point impact on inflation for each shock.

• Global shocks display directional asymmetry. They contributed more to tightening phases than to easing phases of monetary policy over the 1999-2019 period (Figure 5). For example, global monetary policy shocks play little role in explaining reductions in interest rates, but often contribute significantly to rate hikes. Domestic monetary policy shocks, in contrast, contribute meaningfully to rate cuts, but less to rate increases. Global shocks, therefore, appear disproportionately associated with tightening cycles.

Figure 5 Contributions of shocks to interest rates during tightening and easing episodes

Notes: Figures show the historical decompositions of the level of domestic policy interest rates during tightening and easing phases for monetary policy. The dates for the monetary policy phases are from Forbes, Ha, and Kose (2024, 2025). The estimates are based on the FAVAR, as explained in Figure 1 and Forbes, Ha, and Kose (2026).

• Monetary policy responds differently to global and domestic shocks. Over the full sample period from 1970 through 2024, supply shocks (both global and domestic) explain a larger share of the variation in inflation and output than in interest rates, consistent with models suggesting that central banks can ‘look through’ at least some supply disturbances (Bandera et al. 2023, Tenreyro 2023). Since the late 1990s, however, and especially during 2020–2024, global supply shocks have explained a larger share of the variation in interest rates than in inflation and output (Figure 6). The opposite pattern holds for domestic supply shocks. This suggests that central banks have become less willing to ‘look through’ global supply shocks than domestic ones. As global supply disturbances have become larger, more persistent, and more volatile, policymakers appear to respond more forcefully.

Figure 6 Contributions of seven shocks to the variation in domestic interest rates and inflation

Notes: “Oil” = oil price shock, “GS” = global supply shock, “GD” = global demand shock, “GMP” = global monetary policy shock, “DS” = domestic supply shock, “DD” = domestic demand shock, “DMP” = domestic monetary policy shock. The figure shows forecast-error variance decompositions of domestic inflation (left columns) and interest rates (right columns), based on averages across 13 advanced economies from the FAVAR model, as explained in Figure 1 and in Forbes et al. (2026). The pink horizontal lines indicate the sum of the contributions of global and domestic supply shocks and oil price shocks.

Monetary policy needs to adapt

These findings pose a challenge for central banks, as many core models, frameworks, and communication strategies were built around the characteristics of previously dominant domestic shocks. The evolving nature of shocks may require adjustments to the standard New Keynesian models that underpin central bank policy analysis. Global shocks differ systematically from domestic ones: they have a larger supply component, greater volatility, more persistent effects on inflation, and asymmetric impacts (contributing more to increases than decreases in interest rates).

These differences suggest that monetary policy models may need to move beyond assumptions that shocks are temporary, linear, and symmetric. Instead, models should allow for a more prominent role of global shocks and for larger, longer-lasting, and potentially nonlinear effects. If global supply shocks are persistent and harder to reverse, their inflationary impact may be more difficult to look through, increasing the likelihood of sustained policy tradeoffs between price stability and employment (Forbes et al. 2025).

Our analysis also has important implications for ongoing framework reviews at major central banks. In a world where global shocks are more frequent, larger, and more persistent, policymakers may need to reconsider whether existing reaction functions remain appropriate. Questions arise about how forcefully to respond to large shocks and whether narrow point inflation targets remain realistic.

Finally, the growing role of shocks from “heaven” complicates forecasting and communication. Global shocks are harder to predict and often stem from geopolitical or non-economic events. In this environment, scenario-based analysis may be more valuable than relying solely on a central forecast, helping clarify how policy would respond to different global disturbances and improving transparency about trade-offs.

As geopolitical tensions, trade fragmentation, and climate-related uncertainty persist, shocks from “heaven” are likely to remain important drivers of business cycles. This implies that monetary policy frameworks, models, and communication strategies also need to evolve. Understanding both heaven and earth, and how they interact, is essential for central banks navigating today’s complex macroeconomic environment.

Source : VOXeu