Governing Supply Shocks: Central Bank Instruments, Fiscal Space and Financial Resilience

, and | 30 October 2026
Fiscal, Monetary, Policy Briefs | Tags: Energy, Financial Supervision, Global Value Chains, Governing Finance, Novel Risks

This policy brief builds on the discussions held during a roundtable on “Governing supply-side shocks – Central bank instruments and financial resilience” convened by the ASEAN+3 Macroeconomic Research Office (AMRO), the Council on Economic Policies (CEP) and the South East Asian Central Banks (SEACEN) Research and Training Centre in June 2026. 

 

Novel risks are expected to intensify supply shocks. This has considerable implications for monetary policy, fiscal space, and financial resilience. With potentially compounding and cascading effects, financial authorities might have to adopt more preventive measures and adjust their reaction toolkit. Key novel supply-side risks include geopolitical tensions, adverse demographics, energy shortages, and events related to natural catastrophes, climate change and environmental degradation.

Central banks’ policy response to manage supply-side inflation comes with considerable trade-offs. Both standard options, tightening or looking through, have drawbacks. Tightening works on the demand side: it is of limited effectiveness in reducing the initial price hikes associated with supply constraints, and puts additional pressure on economic activity and investment in an already suffering economy. In the worst case, tighter monetary policy tips the economy into recession and harms investments that are needed for future resilience. At the same time, re-anchoring inflation expectations once they have de-anchored oftentimes requires much more aggressive tightening than would have been required in the first place. More nuanced and differentiated instruments are useful to ensure that tightening does not choke investments and economic activity in critical sectors.

The recent past shows that pre-shock conditions very much determine the monetary policy scope once a shock hits. However, even for those economies that managed the most recent supply shock relatively well, the relative position of strength cannot be taken for granted. Instead, resilience to various novel risks needs to be actively built and maintained. In addition to the need to build resilience, three core challenges make monetary policy in times of supply shock crises increasingly complex.

First, eroding fiscal space reduces the fiscal ability to absorb the supply-shock burden and could intensify fiscal dominance. Each shock limits the policy space for fiscal authorities to deal with the next one. This could considerably impact the optimal monetary policy response and its effectiveness. Also, overreliance on fiscal measures could intensify fiscal dominance over monetary decisions, which limits the monetary policy space further.

Second, a looming insurance protection gap increases the economic vulnerability to supply shocks. The issue of insurance protection gaps is associated with many novel risks. This has implications for the optimal monetary response once such risks materialize. Where losses remain uninsured, loss-absorption capacity is limited and the monetary stance hits potentially harder than initially intended. The optimal response function might have to be adjusted, and overall monetary policy space might become considerably constrained. In addition, a widening insurance protection gap oftentimes shifts losses to the public balance sheet. The gap itself could become a contingent fiscal liability that contributes to the erosion of fiscal space.

Third, financial instability and financial dominance add another constraint to the monetary response. A tighter stance on top of the first-round effect of the shock raises default risks. Depending on financial institutions’ interconnectedness and potentially lax pre-crisis supervisory scrutiny, this might put the financial system at risk. If supervision is designed to keep the financial system’s critical functions running through a crisis, rather than to keep every individual institution solvent, central banks might be able to act more decisively when needed. This reduces the risk that individual failures disrupt the system as a whole, and thereby the degree to which financial dominance constrains monetary decisions.

A further cross-cutting consideration is technology-driven change in the financial sector. New actors are entering the market with AI and fintech-based services. Under inflationary pressure, households and firms might shift toward digital payment providers and more easily accessible non-bank credit, which brings new actors into the system and makes policy-rate pass-through less predictable. This could require extending supervision to the firms providing these services and reviewing whether current policy instruments still work as money and collateral take new forms. At the same time, digital wallets, CBDCs and tokenized collateral may give central banks and fiscal authorities more direct ways to reach households and firms for monetary policy transmission and targeted support.

When coordinating with the fiscal authorities on the appropriate reaction, central banks might want to emphasize the need to keep the price signal of the initial supply constraint intact. This is needed to ensure that the supply constraint is not further aggravated by artificially reduced prices, thereby potentially prolonging the supply shock by boosting demand. If needed, supporting vulnerable groups directly would be more advisable than subsidizing consumption of the scarce good.

Looking ahead, a comprehensive strategy for central banks to manage supply shocks entails both preventive and reactive measures. Given that the scope of the supply shock and the conditions on which it lands very much determine the monetary policy space, central banks have a genuine interest in investments that reduce exposure to known shock drivers ex ante. They could consider implementing, for example, targeted facilities that support investments in resilience before shocks hit. When a shock occurs, similar targeted facilities could ensure that central banks’ differentiated response does not disproportionately discourage capital-intensive investments needed for longer-term resilience and sustainable prosperity. From a financial stability perspective, introducing resilience-oriented capital buffers composed of absorption components and components that support investments in resilience ex ante could be considered. In addition, moving from balance sheet protection to functional supervision could be decisive to reduce financial dominance once a shock hits.

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