Strengthening foundations for the future

1. The Annual Economic Report

Presenting the BIS flagship report at the yearly shareholders' meeting of the BIS in Basel, its General Manager framed the past year as a mix of progress, from rapid advances in artificial intelligence, and peril, from renewed inflation, financial fragilities linked partly to AI enthusiasm and heavy public debt. A second chapter studies how high debt and changing bond markets complicate central banking, and a third, presented by a colleague, argues that new digital forms of money only work if built on proven institutional foundations. The common message is that each policy area gains room to act when the others are disciplined.

2. Why the world absorbed the tariffs

A year earlier, many expected US tariffs to hit growth and trade hard. Three things limited the damage. Effective US tariff rates ended close to 10% on average rather than the more than 25% announced, thanks to deals and exemptions, which explains about a third of the later upgrades to 2025 growth. Firms adapted by shipping early, rerouting goods and absorbing part of the cost in their margins. And enthusiasm for AI triggered a wave of spending on data centres and related equipment, lifting US investment and Asian exports and keeping financial conditions easy despite uncertainty. By the end of 2025, world growth was almost back to its pre-tariff forecast.

3. A historic oil shock

The year began strongly until the Middle East conflict. Shutting the Hormuz strait removed a larger share of world oil supply than the crises of the 1970s, and growth forecasts were cut across countries. Markets stayed calm, betting on a quick settlement, and signs of a lasting reopening brought relief. He warned against complacency: production halted across the region will take time to restart, damaged facilities and shipping routes need repair, and rebuilding depleted oil stocks could keep demand and prices high.

4. Four pressure points

The report identifies four sources of strain. First, inflation: global inflation has risen by about one point since the conflict began, and higher prices for inputs such as plastics and fertilisers can keep pushing consumer prices up after oil calms down, while recent memories of high inflation could unsettle expectations faster than before; more slack in labour markets and higher starting interest rates than in 2021 help. Second, AI: task-level studies show big efficiency gains but economy-wide effects are still small, and sectors more exposed to AI in the United States already show weaker job growth. If AI lifts productivity durably, the neutral interest rate rises; if automation squeezes wages and spending, a shortage of demand could reverse that, with matching consequences for inflation if policy misjudges it. Investment may also overshoot as firms race for market share, and past technology booms, from canals and railways to the dotcom era, often ended abruptly. Third, financial vulnerabilities: risk premiums are compressed, households hold more shares than in the past, AI firms and their suppliers increasingly borrow, some financing is circular and opaque, and private credit is growing, so a disappointment or a rate rise could tighten conditions sharply. Fourth, public finances: debt in many economies is near its highest since 1945, conflicts add spending demands, and interest costs and refinancing needs are rising.

5. Debt and new bond market players

Debt grew through repeated crises, but also because governments loosen policy strongly in bad times and tighten too little in good times, and since 2008 they have reacted even less to rising debt. Without consolidation, ageing, infrastructure and defence costs will push debt higher still, and it would be unwise to test the limits. Bond markets have also changed: pension funds and insurers remain steady buyers, but leveraged hedge funds financed by short-term repo, often with little or no margin, now play a much larger role in US and European government bonds. Liquidity that looks abundant can disappear under stress. The old link between weak sovereigns and weak banks has faded as banks are stronger, but turmoil can now spread more quickly via repo funding, from one country to another and from hedge funds to the banks tied to them. BIS estimates suggest that the chance of severe Treasury market stress is roughly ten times higher when debt is in its top tenth than in its bottom tenth, and also much higher when non-banks hold a large share of government bonds.

6. Three challenges for central banks

First, when investors reprice fiscal risk, bond yields jump and currencies fall; activity weakens, and prices first rise through expectations and import costs before falling later, a pattern long familiar in emerging markets that may spread to advanced ones. Second, calibrating policy gets harder: with high debt, rate rises hurt output more through debt costs, wider spreads, bondholder losses and forced deleveraging, but may cut inflation less because interest income supports spending and expectations react less; euro area evidence shows smaller price declines after tightening in high-debt countries. Third, market dysfunction can force central banks to intervene, yet repeated rescues encourage leverage, blur the policy stance, weaken fiscal discipline and raise doubts about independence.

7. What policymakers should do

Central banks should watch for second-round effects, keep expectations anchored and choose strategies that hold up across many AI scenarios, putting medium-term price stability first even when this burdens public finances, since credibility lowers long-term rates. Independence is vital but not sufficient. Governments should consolidate in good times within credible medium-term frameworks, protect growth-enhancing investment and pursue reforms that spread AI's gains. Regulators should apply equal rules to equal risks whatever the type of institution, curb leverage, liquidity mismatches and fragile funding, and keep up with AI and cyber risks. Liquidity backstops should be temporary, targeted and reversible, like the Bank of England's 2022 intervention; lending directly to non-banks could replace asset purchases if well regulated. Acting now costs less than acting later.