Why climate change is relevant to monetary policy

Until very recently, climate change has not been considered relevant for monetary policy. A key obstacle was the divergence of horizons, which reflects a consensus that monetary policy smooths economic fluctuations around their long-term growth trajectory but rarely affects trends. Climate change, by contrast, has been significant on a wide horizon for decades (Brunnermeier and Landau 2020).

However, the notion that climate change and monetary policy are not seemingly related is now being re-evaluated in various ways (ECB 2021). First, there is a growing awareness that, after decades of delay, transformation is imminent. The gap between the horizons of climate change and monetary policy can thus narrow. Second, more frequent, catastrophic climate catastrophes are increasingly challenging the notion that climate change is something long-term. Indeed, a number of recent studies have documented that climate-related risks are already having a significant impact on inflation (Moessner 2022, Faccia et al. 2021, Konradt et al. 2021).

Reflecting this changing consensus, recent literature has highlighted three main channels through which climate change can affect monetary policy:

• First, climate change and its response policies can affect the structure and dynamics of the entire economy and financial system (ECB 2021, Caselli et al. 2021). This could have a direct effect on the central bank’s inflation targets, create financial instability and potentially affect interest rates (And *) And the ‘room’ available for conventional monetary policy, we will discuss further below.
• Second, climate change could weaken the transition to monetary policy through its impact on financial markets and the banking sector. For example, a sudden reassessment of climate-related financial risks can cause damage to the financial system and disrupt the flow of funding to the real economy. Less efficient transmission related to financial fragility, such as the response to physical risk in banks, can also complicate the conduct of monetary policy.
• Third, climate change at various levels could increase the risk of assets on the central bank’s balance sheet, leading to potential financial losses. Climate change risks can transform into higher debt risk by affecting the ability of adversaries, issuers and other lenders to discharge their obligations. Central banks face such risks directly and potentially through the holding of their financial assets. These can also be expressed indirectly on small horizons, for example through collateral pledged by opponents.

Thus, central banks need to assess the economy, the outlook for inflation and the effects of climate change on financial markets. Several central banks have begun to incorporate the effects of climate change into their policies. To support these efforts, the Network for Greening the Financial System (NGFS) has published a number of reports, including Climate Situation and Research Priorities for the Impact of Climate Change on Central Banks (NGFS 2021). The ECB has dedicated an entire workstream to climate change as part of its recent Strategic Review (ECB 2021).

What is the impact of monetary policy management?

Climate change will complicate the assessment of monetary policy position, the nature (supply and demand) of which will be difficult to identify as a source of more frequent, intense and endless shocks to the economy. Frequent, unilateral push will require a more active and stable role of monetary policy. Monetary policy will often face trade-offs between output and inflation stability.

Traditionally, central banks calibrate a shock response depending on its size and stability. If the push is considered short-lived and does not seem likely to affect the medium-term inflation outlook relevant to monetary policy, central banks may “see through” the push. However, as climate change further stabilizes the frequency and intensity of supply shocks, such shocks may become increasingly difficult for central banks to ‘see’. If the shocks continue to be more persistent and there is a risk that they could de-anchor inflation expectations, monetary policy measures can be guaranteed (Schnabel 2022).

Climate change can also make it difficult to identify the position of a monetary policy that is considered ‘neutral’. Normal rate of interest, And *, Provides an important benchmark for assessing how consistent the position of monetary policy is at the policy rate level. Several risks associated with climate change could imply a damp energy And *On top of the factors that have already driven its secular decline over the past few decades.¹ At the same time, green investment and new technologies can push And * Up, everything else being equal. The net effect of these two opposing forces is uncertain. But if downward forces prevail, lower r * will reduce the policy space for conventional monetary policy. Among other things, it will strengthen the case for non-standard measures to be part of the general monetary policy toolkit.

ECB (2021) presents some model simulations of how the physical and transformational risks associated with climate change may be combined with existing financial and fiscal fragility, which in itself may result in the realization of climate risk and significantly limit the power of monetary policy. To respond to the ups and downs of the standard business cycle.

Impact for the design of monetary policy framework

Climate change can also have an impact on the design of monetary policy. The most popular monetary policy regime in the world at Boneva et al, focusing on central banks setting inflation-targets. (2021, 2022) We consider how specific design features of these structures may interact and evolve with climate challenges.

Inflation-targeting central banks may re-examine the link between headlines and core inflation when they are assessed as temporary and do not threaten the anchoring of inflation expectations. Appropriate communication emphasizing the relative stability of the underlying inflationary system could lay the groundwork for a policy position to be seen through those shocks.

The relative merits of the point vs. range goal may also be reconsidered. Point targets communicate precisely the central bank’s policy targets, signal the medium-term nature of inflation targets, and anchor expectations. The range target, or tolerance band, implies the sense that inflation does not have to set a certain value at any given time. They add policy space to handle the temporary push in prices, allowing a certain level of output stability. However, range targets may obscure the accuracy of the inflation target and lead to the expectation of less stable inflation in situations where a strong inflationary push may increase the risk of de-anchoring.

On the target horizon, as climate-related shocks affect economies across different horizons, and with varying intensity, inflation-targeting central banks may have to monitor the optimal length of the policy horizon. Although long-term horizons can limit output and employment declines and reduce their volatility, under flexible inflation targets, the central bank’s credibility could be at risk if the time horizon is stretched too far into the future and inflation misses become too frequent.

Permanent effects, especially change policy, can further emphasize the volatility of inflation and the flexibility of trend policy. At the same time, since the credibility of the central bank may be questioned if inflation targets are interpreted too flexibly and inflation misses become too frequent, clear communication about the central bank’s policy intentions will be essential to reduce credibility losses. However, given our still limited knowledge of the potential long-term effects of climate change on the economy and inflation, it is likely to be too early to make a definite impact on the design of monetary policy at this stage. These will only appear over time.

Author’s Note: The opinions expressed herein do not necessarily reflect those of the author and the European Central Bank (ECB) or the Eurosystem.

References

Boneva, L, G Ferrucci and FP Mongelli (2021), “To Be ‘Green’ or Not: How Monetary Policy Can Respond to Climate Change?”, Action Paper Series, No. 285, ECB.

Boneva, L, G Ferruchi and FP Mangeli (2022), “Climate Change and the Central Bank: What Role for Monetary Policy?”, Climate Policy.

Brunnermeier, M and JP Landau (2020), “Central Bank and Climate Change”, VoxEU.org, 15 January.

Caselli, F, A Ludwig and R van der Ploeg (2021), “No Brainer and No Lesser Fruit in National Climate Policy”, VoxEU.org, 08 October.

ECB (2021), “Climate Change and Monetary Policy in the Eurozone”, Action Paper Series, No. 271, ECB.

Faccia, D, M Parker and L Stracca (2021), “What We Know About Climate Change and Inflation”, VoxEU.org, 12 November.

Konradt, M and B Weder di Mauro (2021), “Carbon Taxation and Inflation: Evidence from Europe and Canada”, VoxEU.org, 29 July.

Moessner, R (2022), “The Impact of Carbon Prices on Inflation”, CESIFO Working Paper, No. 9563.

NGFS (2021), “Adapting Central Bank Activities to a Heated World: Reviewing Some Alternatives”, March.

Schnabel, I (2022), “Looking Through High Electricity Prices? Monetary Policy and Green Transformation”, Virtual Annual Meeting Speech at the American Finance Association 2022.

Endnote

1 For example, high temperatures and high sickness can reduce productivity and labor supply. Capital may be redistributed to support the adaptation system, while climate-related uncertainties may increase cautionary savings and reduce incentives for investment (see ECB 2021).