Pablo Hernández de Cos of the Bank for International Settlements argues policy discipline is needed to tackle economic pressure points

By Pablo Hernández de Cos*

Global economic pressure points are complicating central banks’ mission to preserve price and financial stability. Financial and fiscal fault lines may imperil economic progress and threaten future prosperity. The tide may turn on the artificial intelligence (AI) boom and more frequent supply shocks make inflation more persistent.

While the economy and financial system have proved resilient so far, we cannot take this for granted. The current challenges demand decisive and disciplined action to reinforce economic foundations and safeguard the financial system for the future. Public policy must focus on three priorities: securing price stability, restocking the public purse and shoring up financial stability beyond the banking perimeter.

In our Annual Economic Report, we at the Bank for International Settlements highlight four pressure points for the global economy: resurgent inflation, AI exuberance and financial vulnerabilities. Compounding these risks, and closing out the list, is a backdrop of public finances already under strain.

Inflation has made a comeback. The closure of the Strait of Hormuz was the latest in a sequence of supply shocks. It triggered a crisis in the supply of energy and other raw materials, driving a surge in prices across the globe that may linger. A key question is whether initial price increases will become ingrained. Memories of the pandemic-era inflationary spiral remain fresh, heightening the risk that businesses and households could lock into a cycle of higher prices. Such dynamics put further pressure on increasingly indebted public purses.

AI represents the most transformative technological breakthrough of our generation. It promises leaps in productivity to boost consumption and drive long-term growth. But other outcomes are possible. AI-driven automation could also lead to job losses, dampening consumption, stifling innovation and ultimately capping economic growth. The impact on inflation is equally uncertain.

Policymakers must therefore tread carefully, balancing the promise of AI-fuelled productivity with the risks of uneven economic gains.

The current wave of AI optimism has also sparked an investment boom that carries the risk of overheating. History offers cautionary tales, from the railway mania of the 1840s to the dotcom bubble of the late 1990s, where technological breakthroughs triggered speculative excesses. AI could follow a similar path if investment fails to deliver lofty returns. A growing reliance on debt amplifies risks, making the sector more vulnerable to abrupt corrections.

Future fiscal pressures could unfold under less benign conditions than in the past. Growing strains on the public purse span both advanced and emerging market economies. Debt levels are near post-World War II highs. Governments tend to spend aggressively during downturns yet fail to rebuild buffers during periods of growth. The point at which debt will become unsustainable is uncertain.

Governments need to consolidate their budgets during good times to create room for manoeuvre during adverse shocks, which intensify pressures on public spending. The focus should be on boosting productivity, expanding the tax base, attracting private capital and freeing up resources for critical infrastructure.

Financial vulnerabilities may be reaching a tipping point. Stretched asset prices can unwind sharply in the face of rising interest rates or disappointing AI payoffs. A larger footprint for non-banks adds another layer of complexity. Hedge funds have taken on an increasingly large role in sovereign debt markets, becoming major holders of government bonds – especially in major advanced economies. Their reliance on short-term funding makes the system more fragile.

This evolving landscape has created a new sovereign-financial nexus, where stress could spread rapidly across borders and between financial institutions of all stripes. Sovereign bond values are increasingly prone to sharp shifts, reflecting concerns about liquidity and fiscal sustainability. High leverage can amplify such shifts, increasing the risk of market dysfunction.

These pressures create challenges for central banks. There may be cause to step in to stabilise malfunctioning markets. Yet frequent or large-scale interventions carry significant costs, including encouraging excessive risk-taking, blurring policy signals and weakening fiscal discipline. Central bank backstops should be carefully designed to be temporary and targeted, to address market stress without encouraging irresponsible behaviour.

To preserve the purchasing power of households and firms, central banks must remain resolute in their mission to achieve price stability in the public interest. They must be able to do this without short-term political interference. This allows them to anchor inflation expectations and stabilise long-term interest rates.

Regulation also has a crucial role. Policymakers must apply similarly stringent standards to similar risks, whether they originate in banks or non-banks. Strengthening safeguards will enhance the resilience of the financial system.

To lay the groundwork for a more stable and resilient global economy, policymakers must navigate the crosscurrents of AI progress and the perils of higher inflation potentially persisting, high public debt and financial vulnerabilities. Delays will be costly and increase the chance of tough choices in the future. Addressing these challenges will require decisive action across monetary, fiscal and regulatory policies as well as continued international cooperation.

*Pablo Hernández de Cos is General Manager of the Bank for International Settlements.