The 2020s have been defined by repeated negative supply shocks, pushing inflation into a higher, more volatile regime than any seen in 40 years.

The United States has seen core inflation remain well above the Federal Reserve’s 2% target for over five years, reaching levels not experienced for decades. Annual inflation rose 4.2% in May from a year earlier, its highest rate in three years as mounting energy costs and stubborn services inflation continued to drive prices higher. Similar dynamics have occurred in most developed countries.

On June 11, the European Central Bank raised interest rates by a quarter of a percentage point, noting that “the war in the Middle East is generating inflation pressures, and the decision to raise rates is robust across a range of scenarios mapping out how the shock might evolve and affect the medium-term outlook for the euro area.’’ Several members of the Federal Open Market Committee are calling for an abandonment of the rate-cutting bias in the statement and for the communication of a more symmetric outlook for rates, with hikes possible later this year.

Inflation Regime Shift

All of this points to a possible regime shift in inflation across developed economies, one that would demand not just higher rates, but a new way for central banks to communicate. Kevin Warsh, the Federal Reserve’s new chair, presents an opportunity for the U.S. central bank to communicate differently. He criticized the use of “forward guidance,’’ a technique where central banks explicitly provide their views about the direction of rates. Some market participants anticipate guidance to be taken out of the statement entirely at Warsh’s first meeting as chair on June 16-17, or even anticipate the new chair to decline to provide his own forecast or rate outlook in their quarterly projections.

The Iran conflict is a real-time reminder that geopolitics has changed, and the intersection of geoeconomics, AI, and energy is generating inflationary pressure that is likely to persist in the near to medium term.

So have inflation dynamics changed, particularly in how consumers and firms form expectations? Or is it simply the frequency of supply shocks that has increased? Or both? These are empirical questions, and economists will need time to provide definitive answers. Central bankers, however, don’t have this luxury. They must make real-time decisions about policy in an environment of enormous macroeconomic uncertainty. With the frequency of supply shocks rising, uncertainty about inflation persistence has become a key risk parameter.

Lasting Instability

“That period of relative stability may now be giving way to one of lasting instability resulting in lower growth, higher costs and more uncertain trade partnerships. Instead of more elastic global supply, we could face the risk of repeated supply shocks,” ECB President Christine Lagarde warned a 2023 speech at the Council on Foreign Relations.

Lagarde further addressed the need for central banks to adapt how they manage monetary policy, citing past mistakes. Central banks in the 1970s “failed to provide an anchor of monetary stability and inflation expectations de-anchored – a mistake that should never be repeated for as long as central banks are independent and have clear price stability mandates,’’ she noted.

Inflation is rising again across most developed countries due to the Iran conflict. Stable longer-term inflation expectations provide some comfort, along with falling oil prices and a tentative U.S.-Iran peace agreement. But central banks must follow Lagarde’s 2023 prescription and communicate a readiness to act.

The Australian and Norwegian central banks have led the way in unwinding rate cuts from 2024 and 2025, demonstrating the primacy of the inflation target in monetary policy decision making.

Investors in the U.S. and Europe are slowly recognizing the prospect of a fundamentally changed global economy, one much more prone to negative supply shocks. As a result, they are now pricing in the possibility that policy rates may have to increase in the next few quarters. This has also been accompanied by a sharp repricing of the long end of the yield curve across developed economies.

Activist Central Banks

This means much more “active” central bank policy making, where interest rates are raised and cut much more regularly than in previous cycles, and term premiums – the extra compensation investors demand for the risk of holding long-maturity sovereign bonds — are greater to compensate for both higher inflation levels and volatility.

This will require central banks to become more flexible and evolve how they communicate policy, conditioning markets for an environment where rates may need to move more actively in either direction.

Forward guidance, as practiced over the past two decades, is poorly equipped to inform investors and will likely fade.  When inflation is subject to recurrent target overshoots due to supply shocks and uncertainty is high, central banks cannot credibly provide a clear most probable path for policy.

The framework of central bank communication we saw in the late 1990s through mid-2000s may become the norm again, where central banks give a much looser sense of whether they have an easing or tightening bias, and focus on flexibility in reacting to shocks.

Risk management should play a pivotal role in central bank policy making and communication, along with necessary judgment.

Scenario analysis is a more useful tool than the modal forecast approach of recent years, helping markets understand potential alternative policy paths and how central banks might react to different shocks.

There are challenges related to designing scenario analysis — for example, whose scenario? Staff? Policymakers? And should the probability assigned to different scenarios be revealed? Those challenges should not be an excuse to avoid tough decisions.

What the policy choices of this month make clear is that central banks have moved into a different regime from what we have seen over the last 30 years.