Debate over climate and inflation heats up

A lively debate is underway over how central banks should best guide inflation in relation to climate change during the transition to net-zero emissions.

Although the current global spike in energy prices is not generally attributed to action to address climate change, many experts agree the shift to clean energy will have to be carefully managed over the coming decades in order to minimise any adverse impact from rising costs – so-called ‘greenflation’.

Isabel Schnabel, a board member at the European Central Bank (ECB), weighed in on the matter in a speech earlier this month, saying that the higher energy prices the bloc is experiencing could become a persistent feature as its climate policies take effect. She said although higher carbon prices are desirable, they may pose challenges if cheaper and greener sources of energy are only gradually able to meet rapidly rising demand.

She said governments should act to limit the social impact of cost pressures, but that monetary policy will have to address the price rises if they threaten medium-term price stability.

Stan Jourdan, the director of Brussels-based thinktank Positive Money Europe, stressed in a Twitter thread that it is the failure to support clean energy and energy efficiency measures that is causing the current instability in energy markets. He warned tighter monetary policy could be counterproductive, as slowing down the whole economy would also put a brake on green energy investments, which are critical to solve the energy crisis in the first place.

“I would therefore argue the energy price conundrum will force the ECB to move beyond its old-fashioned one-size fits all approach to monetary policy and adopt what Eric Lonergan, Megan Greene and others have called a ’dual rate’ policy.” he wrote.

Specifically, Jourdan backed the proposal for a preferential “green discount rate” on the ECB’s targeted refinancing operations. This would involve offering banks cheaper financing proportional to the green energy investments in their loan book. The idea was the subject of a recent report by the Council for Economic Policies, and featured in a series of possible climate-friendly monetary policies published last year by the ECB.

The argument that central banks should consider the trade-offs involved in any near-term tightening of monetary policy is supported by a recent paper published by Vivid Economics. The study models the macroeconomic impacts of a carbon tax accompanied by significant public expenditure on low-carbon infrastructure, as well as any potential central bank response.

The researchers project that in such a scenario, central banks would respond to higher inflation in the near term by raising rates, but ease them in the medium to long term as the impact on inflation is outweighed by a negative impact on output. Their model also suggests that the underlying ‘neutral’ interest rate will be reduced as a result of the transition. They therefore conclude that policymakers may be able to avoid raising rates in the near term, given that they would likely have to reduce them again later.

In her speech, Schnabel acknowledged that central banks have tended to “look through” energy price shocks, saying such an approach was justified if they expect price stability to be restored over the medium term and inflation expectations remain anchored. But she argued that the green transition poses a unique challenge, and a policy response could be necessary if inflation expectations risk becoming destabilised, or if price pressures occur alongside a boost in growth and demand.

Separately, the Network for Greening the Financial System last year offered a warning against any bid to justify scaling back climate action on the basis that doing so would help to tackle inflation. Its latest climate scenarios found that although delaying emissions reduction measures might keep long-term interest rates muted over the next decade, they would likely rise sharply over the following decades, outpacing the increase under the net-zero scenario.