Should monetary policy include an ecological dimension in its objectives? And can she? The debate is between central bankers. While there is undoubtedly room for maneuver, we should not expect miracles.
Global central bank policy has always been the subject of much debate. In particular, there are many questions about the efficiency of their monetary policies, these policies which are essentially based on the mandate and missions of these fundamental institutional establishments which demonstrated their necessity during the waves of crises which have shook Europe and the world.
While the unconventional monetary policy conducted in the aftermath of the global financial crisis was effective in mitigating the effects of the crisis, the recent return to conventional rate policies has proven effective in correcting post-Covid-19 inflation. But faced with the ever-increasing threat of a generalized climate shift, some economists are nevertheless beginning to discuss the scope of the traditional missions of central banks with regard to transformations of today’s world.
Decarbonization, a viable objective?
The climate emergency is indeed one of the pivot points of this discussion and more precisely, the existential questions linked to climate challenges, the problems of massive destruction of ecosystems and the conduct of growth and inflation policies which all highlight the possibility of renewing the mandate of central banks. It would thus be a question of broadening these mandates in order to integrate the question of ecological transition, thus breaking with their traditional monetary policy) – a policy that has remained unchanged for over a century now.
But is it really viable to include decarbonization or natural environment protection objectives in their mandates? Does this not introduce problematic distortions which would affect the conduct of their traditional missions of combating inflation? Is there even a risk of politicizing the central bank and calling into question its independent character? The answers to these questions are far from unanimous.
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The central bank of England at the forefront
The Bank of England (BOE) has been particularly avant-garde in its desire to broaden the framework of its missions to objectives of reducing the impact of climate change, unlike the governor of the American central bank, who has remained arcane. committed to the mandate and traditional missions vested in the Fed. Thus, Andrew Bailey stood out in particular for very voluntary declarations. His speechdelivered in 2021, suggests that the effects of climate change are important for monetary policy and employment.
Above all, it is about decarbonizing the central bank’s balance sheet and promoting a portfolio of values considered more sustainable. By decarbonizing we mean the desire to separate from polluting assets such as hydrocarbon or industrial chemistry companies. It would therefore seem obvious that the effects of climate change would certainly affect the risk factors that the mission of the central bank is precisely to curb.
Very recently, however, these advances have been thwarted by a spectacular backpedaling. Bailey’s political orientation will indeed undergo a violent stoppage. In the most recent official statement on its objectives and missions, the climate objectives are described, at best, as secondaryeven if we perceive, on these questions, serious tensions in the British political class.
Thus, we would come back to the idea that integrating factors of sustainable development or reduction of greenhouse gas emissions into the atmosphere were not really the responsibility of central banks. Hence a feeling, depending on the establishment, of waltz-hesitation.
Interest rates and climate change: loose connections?
While Mr. Powell’s view of the Fed’s role contrasts with that of major European central banks which have integrated green economy efforts into their policies, it takes into account that American policy is in species, much more divided.
For him, without a real political decision, therefore in the absence of explicit legislation from Congress, it would be inappropriate to use monetary policy or the supervision tools of the Fed to promote a greener economy or to achieve other climate-related goals. He thus argues that decisions relating to policies aimed at directly combating climate change should be made by the elected branches of government and be subject to public consultation since it is expressed through elections. One of the Fed governors, Christopher Waller, even said that he was not in favor of issuing guidance on the issue, because if “climate change is real (…), I am not “agree with the idea that it poses a serious risk” to the financial stability.
And Andrew Bailey followed suit by saying he would not base his interest rate decisions on whether they help reach the level net zero…
Greening monetary policies: at what cost?
Central banks around the world are mandated to pursue monetary policy that fights inflation. Recently, Jawadi, Rozin and Cheffou tested the possibility of a “greening” of the Fed’s monetary policy and therefore of an alternative monetary policy to address its main mission of price stability while taking into account climate change.
This study showed two interesting results. First, the “greening” of American monetary policy by the Fed (therefore the fact of integrating climate change indices into its objectives) seems feasible, because taking into account climate risk factors in the conduct of policy does not contradict the core mandate of price stability. This could generate a climate risk premium.
Consequently, the measurement of climate risk linked to transition risk and physical risk, by transforming the objectives of a central bank, and therefore the purpose of its actions, necessarily influences its rates. Transition risk is defined as the risks associated with the pace and scale with which an organization manages and adapts to the internal and external pace of change to reduce greenhouse gas emissions and transition to renewable energy and by risk physical risks directly associated to climate change.
Remember that the Taylor rule is called the rule stated by the economist John B. Taylor in 1993. It is a formula used in economics to guide central banks in setting interest rates based on two factors main ones: inflation and the output gap. An augmented Taylor rule would potentially allow central banks to move beyond their traditional mandates, by setting their interest rates based on considerations other than simple monetary stability and the fight against inflation.
Growth and climate change compatible
Second, the Fed’s response to daily produced news on physical and transition risks in particular, and climate risk in general, has been more pronounced since the post-Covid-19 sub-period. Accordingly, the greening of the Fed’s monetary policy does not run counter to its core mandate. In particular, the information provided by the measurement of transition climate risk and physical risk seems to have an increasingly obvious impact on the viability of interest rate forecasts to be implemented. And as a result, an augmented green Taylor rule would thus offer a better fit with the facts than the simple conventional Taylor rule. It remains difficult to ignore the impact of climate change on central bank policy any longer. Furthermore, a focus on climate change would not necessarily come at the expense of economic growth.
However, the expansion of the missions of central banks to ecological and climatic criteria is not as obvious as that. In principle, if central banks were charged with environmental objectives, they should be equipped with effective instruments to achieve these objectives without compromising others. Of course, the financial and macroeconomic risks of climate change are issues that central banks must address anyway. The status quo assumption seems increasingly untenable.
A magic formula
The sole traditional mission of central banks consisting of preserving financial stability, without adding environmental objectives, arguing that these would implicitly be part of their mandateseems inconsistent in view of thefrightening acceleration of climate change.
However, there is a risk that excessive powers will be granted to institutions which have only limited responsibility towards the public. A relatively broad consensus has formed to grant central banks their institutional independence, i.e., to be free from political influence. But central banks that adopted unconventional monetary policies after the 2008 crisis have been increasingly criticized for making policy decisions that critics say go beyond their mandate.
Furthermore, a profound question of credibility does not fail to arise. As influential Berkeley monetary economist Barry Eichengreen points out, central banks must create legitimacy for their actions by clearly communicating their risk assessment and the rationale for their policy actions and if they do not follow this path, it there is a significant risk of lose their independence. The mandates of central banks have broadened, but there are limits linked to the very design of monetary policy.
