July 16, 2026 Navigating Economic Shocks: A Monetary Policymaker’s Perspective Vice Chair Philip N. Jefferson At the Stanford Institute for Economic Policy Research, Stanford University, Stanford, California Share Watch Live Thank you for the kind introduction. I am delighted to be here at Stanford University today to discuss a topic that is central to the Federal Reserve's work: how policymakers analyze and respond to economic shocks in real time. 1 The economy is constantly experiencing shocks that change economic conditions and that policymakers must consider. Today, I will focus on shocks that are extremely difficult—if not impossible—to predict, such as the emergence of a pandemic, the start of a war, or a sudden breakthrough in technological advancement. When such shocks occur, the Federal Open Market Committee (FOMC) evaluates them and sets monetary policy consistent with its dual mandate of maximum employment and price stability. This responsibility is both crucial and complex. Since the effects of shocks are uncertain in real time, policymakers must draw conclusions about their nature based on analysis of data, rigorous economic modeling, and careful judgment. Economic conditions also often reflect the effects of overlapping shocks, whose relative importance and interactions must be assessed. Today , I will start by classifying economic shocks and then discuss how monetary policymakers might respond to different types of shocks. Then I will discuss how I am approaching the two significant developments affecting the current juncture: the energy price shock and the macroeconomic effects of artificial intelligence (AI). I will talk about how both might affect monetary policy going forward before taking your questions. Classifying Shocks One simple, yet effective conceptual framework policymakers can use to classify shocks is to determine whether their initial effect is on the demand side or the supply side of the economy. The demand side of the economy comprises household consumption, business investment, government expenditures, and net exports. Demand shocks initially change these expenditures without directly affecting the economy's underlying productive capacity. The supply side of the economy encompasses the structure of its production processes and markets. Supply shocks tend to affect the economy's productive capacity, often referred to as "potential output." Productive capacity captures the available supply of labor and capital as well as the productivity of those inputs. 2 Potential output is the hypothetical level of production that the economy can sustain over the long run while maintaining price stability and maximum employment. 3 Both demand and supply shocks can vary in duration. They may be temporary, causing short-term fluctuations, or they may be persistent, leading to more enduring changes in the economy. The nature and duration of these shocks significantly influence the approach to monetary policymaking, a subject that I will return to shortly. A key concept for analysis of an economic shock is the output gap —a valuable tool for monetary policymakers as we assess economic conditions because it summarizes the strength of demand relative to supply. The output gap represents the relationship between the economy's actual output—typically measured by gross domestic product (GDP)—and an estimate of its potential output. When GDP is higher than potential output, the output gap is positive, and the economy is in a state of excess demand. In this case, employment tends to be above its maximum sustainable level, with upward pressure on inflation. Conversely, when GDP falls below potential output, the output gap is negative, and the economy is in a state of excess supply. During periods of negative output gaps, employment levels typically are below their maximum sustainable point, accompanied by downward pressure on inflation. Without shocks, monetary policy decisions would be consistent with GDP in line with its potential. This alignment would correspond to employment reaching its maximum sustainable level, with inflation stable at our 2 percent longer-run objective. In practice, such conditions rarely occur. Often, economic shocks push GDP away from its potential. While conceptually distinct, supply and demand shocks are difficult to identify, especially in real time. Many economic events do not fall neatly into one category. They contain shocks that affect both demand and supply. Moreover, the persistence of shocks is highly uncertain, and even sophisticated forecasting techniques can struggle to resolve this uncertainty as an event unfolds. With these classifications as a backdrop, let's consider the implications of economic shocks for monetary policy formulation. Responding to Shocks in Real Time Our monetary policy strategy is designed to promote maximum employment and stable prices across a broad range of economic conditions. How we respond to economic events depends on whether shocks create tension between the two sides of our mandate. First, consider a shock that moves the output gap and inflation in the same direction. We may have a positive output gap, with employment above its maximum sustainable level and inflation above 2 percent. Conversely, we may have a negative output gap, with employment below its maximum sustainable level and inflation below target. In both cases, our inflation and employment objectives are aligned; therefore, policy actions taken to address one objective also support the other. With a positive output gap, where we observe both overheating in the labor market and inflation exceeding our target, our policy response would typically involve raising interest rates to cool excess demand. The intent is to bring employment closer to its maximum sustainable level while addressing inflationary pressures. With a negative output gap, lowering interest rates can stimulate the economy, which simultaneously should help increase employment and raise inflation toward its target. Now consider a shock that pushes the output gap and inflation in opposite directions. Policy tightening addresses inflationary pressures but possibly at the expense of employment; easing does the reverse. Thus, we could face a tradeoff, where tightening helps price stability but hurts employment. Given this possible tension, how should I react as a monetary policymaker? The answer depends on the relative size of the economic costs arising from deviations of inflation and employment from their respective longer-run goals and the balance of risks on both sides of our dual mandate. 4 If inflation expectations risk becoming unanchored, then a stronger reaction to the inflation side of our mandate may be warranted. Conversely, if inflationary pressures do not intensify and inflation expectations remain well anchored, then it may be prudent to prioritize the downside risks to output and employment. This response may be especially necessary if weakness in the labor market risks becoming entrenched. Another consideration is whether the shock is expected to be short lived or persistent, keeping in mind that monetary policy actions tend to work with a lag. This consideration is important when deciding whether to respond to the shock or to allow it to pass without a policy response. If a shock is expected to reverse before monetary policy can take effect, looking through it may be the appropriate approach. It is challenging, however, to predict how long a shock may last. The appropriate monetary policy response, again, requires weighing the risks to both sides of our mandate from various actions. When confronted with a single shock, policymakers must carefully identify and respond to the shock. Shocks, however, rarely happen in isolation, further complicating this task. Sometimes the economy faces multiple shocks simultaneously that may affect both supply and demand. Moreover, we face uncertainty about how shocks propagate through the economy. Such complications bring me to the challenges posed by the current juncture. Challenges Posed by the Current Juncture Currently, I am monitoring two significant developments: the conflict in the Middle East and the proliferation of AI. The Middle East conflict is, in part, a supply shock. Global supply chains for oil and other energy-intensive goods have come under stress. The resulting spike in the price of oil, shown in figure 1 , and related products has lowered real incomes and triggered a worsening of financial conditions more broadly. While oil prices have declined from the recent peak, considerable uncertainty remains in the region, which may still weigh on economic activity and inflation. This outcome has put modest downward pressure on aggregate demand. I expect the effects on demand to be muted, however, because the U.S. is now a net exporter of oil and U.S. production is less oil intensive than in the past, as is shown in figure 2 . As shown in the left panel of figure 3 , this supply shock is occurring in an environment in which inflation has already been above the FOMC's target for some time , in part a result of post-pandemic imbalances. At the same time, the unemployment rate, illustrated in the right panel of figure 3, is near a level that most observers view as consistent with maximum employment. 5 These factors confront the FOMC with a delicate balancing act. On the one hand, we face the imperative to address inflationary pressures. On the other hand, we must be mindful of employment potentially moving below its maximum sustainable level. This scenario exemplifies the type of policy dilemma where our dual-mandate objectives are not aligned but rather in tension with each other. Of course, this energy shock also overlaps with the shock stemming from a significant change to trade policy. Recent trade policy changes have had at least near-term effects on output and prices. Those policy changes may alter the economy's productive capacity and have implicati
