Unlock the Editor’s Digest for free
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is the Rene M Kern professor of practice at Wharton School, chief economic adviser at Allianz and chair of Gramercy Funds Management
Economies around the world have been subjected to a common external shock following the outbreak of the Iran war. Yet, reactions among central banks have been quite diverse, judging from the flurry of recent monetary policy announcements. Some have raised interest rates, some have held them unchanged, and a few have even cut.
What makes this policy divergence even more notable is that it also exists within the G7 nations. If there are no appropriate economic policy adjustments in response, the “normal” market reaction could easily aggravate existing imbalances and geoeconomic stresses.
Consider the array of recent central bank decisions. The European Central Bank raised rates, with its president Christine Lagarde keeping the door open for more increases. She also cautioned about the “upside risks to inflation” at a hearing at the European parliament earlier this month.
Japan’s central bank packaged its rate rise in stronger signals on more increases to come. The Bank of England opted to hold rates with its governor, Andrew Bailey, expressing caution about “still some inflationary pressure in the pipeline”. Meanwhile, the Bank of Canada came across as happy to keep rates unchanged for a while
Then there is the globally most consequential central bank, the Federal Reserve. Its recent policy response — the first led by new chair Kevin Warsh — left interest rates unchanged again but as part of an emerging new policy playbook. It is a shift that, judging by the market’s initial reaction to Warsh’s debut press conference, investors have yet to internalise enough.
The new chair has arrived with a sweeping reform agenda, immediately announcing the establishment of five task forces to review communication, balance sheet management, data sources and uses, the inflation framework, and productivity and jobs in a transforming economy. Even more unusual for this traditionally insular central bank, these working groups will include independent outside experts alongside Fed insiders to ensure better cognitive diversity.
This institutional overhaul is as understandable as it is overdue. It follows the multiple mis-steps of the Jay Powell-led Fed. It also comes at a time when the US economy, in particular, is on the cusp of a profound and positive productivity shock.
Away from the G7 economies, the picture is even more fragmented. The latest People’s Bank of China policy measures continue to ease liquidity into a property-burdened economy. Elsewhere, there have been increases from central banks in Indonesia and the Philippines and cuts in Brazil and Hungary.
Four main reasons can be cited for such divergence, even though all these central banks have been facing the same global inflation shock.
First, individual countries’ conditions vary, particularly when it comes to structural and financial resilience. Second, not all central banks share the same legal mandates, historically driven policy biases and institutional pain thresholds. Third, differences in domestic labour market dynamics translate into differences in how quickly wage-setting mechanisms enable a supply-side shock to morph into something broader. Finally, economies possess different exposures to geoeconomic fragmentation, including the rewiring of global supply chains.
Such divergences risk market reactions that accentuate the risks of economic and financial instability. This includes the possibility of exchange rate stress, asset disposals, volatile cross-border capital flows and widening balance-of-payments imbalances.
The required policy adjustments naturally vary from country to country. Having said that, three elements tend to be quite common: deepening productivity-enhancing structural reforms, smart fiscal measures and better partnerships with private capital and across borders. The overarching goal is to enhance economic agility, restore fiscal policy flexibility and secure financial stability.
Ultimately, this episode of central bank divergence is a manifestation of a much broader 2026 theme. The global economy is in a period of structural dispersion in which it can no longer rely on central banks as the “only game in town”. Monetary policy can’t paper over fundamental economic differences. Governments must sharpen their economic strategy and responses, or risk watching the global economy and markets fracture under the weight of increasingly unmanageable imbalances.