Adam Tooze, professor of history at Columbia University and director of the European Institute, suggests that while Fed chair Jerome Powell is a natural monetary conservative, he could be Biden’s shield for advancing the administration’s climate goals.
In the last two years the central banking community has embraced the issue of climate change.
That is not to say that central bankers have been converted to climate activists. That would imply a drop-everything approach to the climate issue, which is nowhere in sight. Nevertheless, to hear Christine Lagarde of the European Central Bank (ECB) telling the Green Swan conference recently that “(o)ur planet is burning” and demanding that central bankers think beyond narrow definitions of their mandate, is a sign of how far things have moved.
Central bankers are no longer strangers in the climate policy space. In light of far-reaching national commitments to achieving net zero by 2050, a wide-ranging re-examination of financial stability regulation and monetary policy tools is under way.
In the last six months, the Bank of England has had environmental sustainability and the transition to net-zero inserted into its core mandate. In its long-awaited strategic review, the ECB stressed the importance of climate. And the Bank of Japan has been authorized to make preferential loans to assist the energy transition.
Of course, the devil is in the detail, and the suspicion of greenwashing is never far away. The ECB may have opened the question of how far financial markets underprice climate risk, but it will be some time before it is clear how this will change its policy on corporate bond buying. The Bank of Japan may have a licence to promote green lending, but it is under no obligation to penalise dirty collateral.
These are valid concerns, but they are directed towards central banks that seem, at least, to be on the move. The one central bank that has not so far taken concrete action or made specific announcements is the most important central bank of all: the Fed.
Removing the political roadblock
In part this is a matter of timing. The Fed is struggling to make up lost ground. The question of central banks and climate policy was first raised by Mark Carney of the Bank of England in September 2015. The Paris climate agreement in November of that year forced the issue into the mainstream. But, with then-President Trump announcing on 1 June 2017 that he was reneging on America’s climate commitments, it was hardly surprising that the Fed was absent from the global policy debate.
With the advent of the Biden administration, the political roadblock has been lifted. The US has rejoined the Paris Agreement. The administration is trying to get a substantial investment package passed by Congress. All of which made the continued inaction of the Fed even more glaring.
In December 2020, the Fed finally joined the global Network for Greening the Financial System. It was the last major central bank to do so.
This spring it has created two internal committees to address the climate issue. The financial stability climate committee is taking a macroprudential perspective considering complex interactions across the financial system. The supervision climate committee is adopting a “microprudential” approach, analyzing risks at the level of individual firms. The Fed has been making enquiries with key banks about the degree of their climate exposure. But, though the tone may have changed, the substance is so far lacking.
A moment of truth came at the Green Swan conference hosted by the BIS in June 2021. On a panel alongside colleagues from around the world, Fed chair Jerome Powell bluntly stated the limits of the Fed’s approach. As far as monetary policy is concerned he remarked, “climate change is not a main consideration”. That is no doubt true for the other central banks too, but they would no longer put it in those terms.
Powell did go on to concede that the Fed is “quite actively exploring exactly what climate implications are for our supervisory, regulatory and financial stability responsibilities”. There was a “lot to like”, he said, about stress-testing banks for climate-related issues. Climate-related financial risk clearly does fall within the Fed’s existing remit. But Powell was no less emphatic on the limits of the Fed’s engagement. The Fed, he declared, is not in the business of setting public policy on climate.
This is a strawman. No one expects central banks, let alone the Fed, to be the lead agency in setting public policy with regard to climate.
Powell is playing to the gallery. As chair, he operates in a space constrained on four sides by mandate, politics, the Fed’s policy instruments and America’s political economy. These constraints are all too real. What is telling is how conservatively Powell is choosing to maneuver within this box.
First is the mandate. “Our mandate hasn’t changed.” As Powell remarked: “We don’t have a secondary mandate to support the economic policies of the government.” This is different to the ECB. But the way the ECB is currently interpreting its mandate to gain freedom of action on climate is a matter of choice and initiative on the part of Lagarde and her team.
The Fed has an obligation to pursue full employment and community development. If the Fed so wished, both could be interpreted as justifying climate action. The Bank of England’s stress on sustainable growth as an objective might offer a model.
One of the reasons Powell is cautious is that, in the US, the very existence of the climate crisis is more seriously challenged by conservative politicians than in any other advanced economy. In December 2020, 47 Republican members of Congress fired a shot across Powell’s bows with a letter noting their concern that the Fed was introducing climate change scenarios into its supervisory stress tests.
They asserted that “methodological challenges” might undermine the effectiveness of this stress testing. On 20 March 2021, Senator Pat Toomey opened a new front by attacking the Federal Reserve Bank of San Francisco, for “publishing politically-charged research on environmental, social, and governance topics like climate change and racial justice”.
This research reflected the “political and normative leanings of unelected Federal Reserve Bank officials”. They thereby “inserted the Federal Reserve into the emotionally-charged political arena – a place where the Federal Reserve seldom has ventured, and for good reason”.
Different policy tools
In the US, this kind of opposition has to be regarded as a given. It should not, however, be allowed to dictate the boundaries of political action. Recognising the threat of climate change is no more a matter of normative leanings – and no more emotionally charged – than worrying about inflation. Both are real risks, which do indeed engage different normative positions and may certainly evoke emotions. But that by itself does not make the climate crisis and its implications for the economy an improper area for central bank engagement, unless you are a climate denier.
A further difference between the Fed and the ECB derives from the nature of their policy tools. The ECB faces an immediate policy imperative to clarify its position because, like the Bank of England and the Bank of Japan, as part of their QE programs all three have bought corporate debt. This forces the issue of whether the portfolio is dirty.
The same is true to a far lesser degree for the Fed. At the height of the Covid-19 crisis in 2020, Powell took unprecedented steps to backstop private credit markets in the US. The Fed even bought some company debt. But the Fed’s portfolio is tiny. It would nevertheless send an important message if the Fed clarified the terms on which it was willing to intervene.
It would be even more powerful if the Fed worked with housing finance regulators to set new standards for the one class of ‘private’ securities it does buy in bulk, GSE-backed mortgage backed securities. If the US is to make the energy transition, the standard ‘conforming’ mortgage, the benchmark in mortgage lending, has to become a green mortgage.
Finally, the Fed’s independence is constrained not only by political forces, mandate and policy tools. It is also constrained by political economy. America’s economy and its financial sector are deeply entangled in fossil fuel finance. The energy transition will generate winners and losers and there are powerful forces resisting that shift. JP Morgan Chase is not just the dominant player in the American banking system; it is also the world’s largest fossil financier.
Finding wiggle room for the Fed
The interests to which it lends have powerful political voices. The Republican members of Congress who wrote to Powell made this explicit. What concerned them about climate stress-testing (£) was that it might “accelerate the ill-advised pattern of ‘de-banking’ legally operating businesses in industries, such as coal and oil and gas, that are politically unpopular to certain vocal policymakers”.
They didn’t complain when QE3 dumped billions in low-interest credit into the expansion of the shale industry. Credit policy has real economy effects. The energy transition will reshuffle the political economy. This summer Christine Lagarde has put the ECB in the vanguard arguing for an accelerated transformation of the economy through the development of green capital markets. If the Fed is abstaining, it is not neutral. It is effectively underwriting the climate status quo.
The Fed is constrained, but in every dimension more imaginative and robust climate leadership could find wiggle room. It should be moving swiftly to incorporate climate criteria across the full range of its regulatory activity. This is a matter not just for micro regulation, but for macroprudential regulation, including the broad remit of the Financial Stability Oversight Council.
Climate deniers who seek to define these issues as ‘political’ and ‘emotionally-charged’ cannot be allowed to set the agenda. Rather than hiding behind the supposed limits of its mandate, the Fed should be asking the question: how will the climate crisis impact American jobs, American communities and American homes. What is it our responsibility to do, here and now?
A second term for Powell?
The question of whether Biden should nominate Powell for a second term will be decided in the next few months. Powell is a Republican insider, and in surviving the Trump presidency that stood him in good stead. When it comes to climate, however, it is tempting to conclude that what the Fed needs is new leadership at the top.
In 2019, Lagarde campaigned for the top job at the ECB on a climate ticket. She continues to stake her presidency on that card. Her tactic is to leverage the groundswell of public opinion on the climate issue against conservative resistance on the ECB’s council. In political terms, activism on climate and in response to the pandemic go hand in hand.
The picture in the US is more complicated. Powell earned immense credit on both sides of the aisle for his dramatic response to the 2020 crisis. He has been similarly supportive of the Biden administration’s fiscal agenda in 2021.
To replace Powell with a candidate more closely aligned with the climate agenda of the Biden administration would be a high risk strategy. Though Powell is unduly restrictive in his vision of the Fed’s role, he is right in at least one respect. The core of the Biden climate agenda lies squarely in the large infrastructure program, which the administration will seek to pass through reconciliation, and major regulatory initiatives to clean up the power sector.
For both, Biden needs to maintain political momentum and avoid distractions. Roiling markets by replacing Powell with a more climate-aligned Fed chair would offer the GOP a dangerous angle of attack in a midterm election year. On balance, Powell and his relatively conservative construal of the Fed’s role, may be a shield that Biden needs to advance the more progressive elements of his climate policy.
The planet may be burning, but if the Fed is to become more proactive on climate then the pressure may need to come from within and by stealth.
This page was last updated September 21, 2021
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