The European Central Bank (ECB) has published a substantive review and analysis of climate change and monetary policy in the euro area, identifying potential problems with monetary policy transmission as a result of climate-related impacts.
Released ahead of the ECB Forum on Central Banking next week, the paper is one of 18 background documents used in the central bank’s recent strategy review. Topics covered include the macroeconomic and financial impacts of climate change, the adaptation of macroeconomic models to reflect these impacts, and the potential monetary policy measures the ECB can take within its mandate to manage and ameliorate climate risk.
Accompanied by an explanatory overview, the document also contains 16 explanatory subsections focusing on topics ranging from the ECB’s economy-wide climate stress test to the macro-financial modelling of carbon tax.
The analysis used the ECB’s New Area-Wide Model of the euro area to show how climate change can interact with existing financial and fiscal fragilities to “significantly restrict the ability of monetary policy to respond to standard business cycle fluctuations”.
The paper shows that as shocks from more frequent and extreme weather events increase, the euro area and global economy will be subject to greater volatility in output and prices. This increased volatility can also result in the effective lower bound interest rate being hit more frequently, particularly if the equilibrium interest rate is also lower.
It also finds that a disorderly transition to a low-carbon economy is “likely to have substantial effects on economic and financial activities, relative prices and inflation, output growth and productivity, and hence on the optimal response of monetary policy.”
The paper is clear on the use of monetary policy for climate change mitigation. Providing policies are not prejudicial to price stability, it recommends the Eurosystem should “seek to choose the configuration that best helps to mitigate the impact of climate change, with a view to contributing to the objectives of the Union”.
Potential monetary policy measures identified for the ECB to address climate risks within its mandate include playing a “catalytic role” in the wider field of climate-related disclosures and implementing its own disclosures, including its corporate bond purchasing programme.
Other measures include requiring disclosures as an eligibility requirement for collateral and asset purchases, as well as considering climate-related factors in the methodologies employed to calibrate its risk control framework and valuation methodologies.
Climate stress tests of the Eurosystem balance sheet, the incorporation of climate-related risks in credit ratings, and “green targeted longer-term refinancing operations” are also included as possible monetary policy responses by the ECB to climate change.
While many of these recommendations match the climate-related proposals of civil society groups, only a selection have been incorporated into the climate action plan approved by the ECB’s governing council last July.
This page was last updated September 21, 2021
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