Forget greenflation, central banks need to tackle fossilflation

This month, the US Federal Reserve and the Bank of England found themselves in the uncomfortable position of raising interest rates to the highest levels in over a decade, while in the same breath warning of impending recession. Despite broad agreement that supply-side constraints are at least as important as excess demand in explaining current inflation, many central banks have doubled down on the swift and aggressive use of the rate hike hammer.

Their logic? Rate hikes ensure that firms and households expect inflation to be controlled, so they will think twice about hiring new employees, raising prices and asking for wage increases. This will in turn control inflation by dampening domestic demand.

Aside from resting on shaky empirical grounds, such a technocratic explanation has been criticised for disingenuously skirting around the painful implications of such a policy. Rate hikes will hit already financially constrained households and businesses, and exacerbate the cost-of-living crisis.

Equally troubling, but far less acknowledged, is the fact that tighter monetary policy threatens to completely derail the energy transition. At this critical moment for both the economic recovery and the road to net-zero emissions, a key question for policymakers is: how to deal with rising prices while also accelerating a green structural economic transition? Are blanket interest rate hikes the only option?

Monetary policy decisions will affect the trajectory of the energy transition

Renewable energy sources are more capital intensive than fossil fuels, which means they have much larger upfront costs and thus face higher funding costs. This relatively higher cost of capital likely means that green investments are more sensitive to interest rate rises, and tighter monetary policy may delay or deter green energy infrastructure projects.

Moreover, higher rates will discourage businesses from investing in electrification and less carbon-intensive production processes. The cost of servicing government debt will also rise, hindering urgently needed public investment in decarbonised energy, transport and housing, as well as investing in reskilling workers for the transition. A delayed transition will in turn heighten the physical and transition risks of climate change, thereby contributing to future monetary and financial instability.

Central banks have so far entirely failed to acknowledge these repercussions for net-zero goals. Instead, some central bankers have chosen to draw attention to greenflation – the false narrative that current inflationary dynamics are in a large part caused by the energy transition. “Climate mania” is constraining fossil fuel supply, so the story goes, while carbon pricing is hurting miners, and making commodity prices more expensive.

Such so-called arguments have been widely debunked. But they represent a dangerous straw man distraction to the reality that should be occupying policymakers: that if governments had invested in green energy infrastructure a decade ago, consumer prices would arguably be a lot less exposed to volatile increases in oil and gas prices.

It is certainly true that the dynamics of today’s inflation are myriad, spanning from shortages in grain, semi-conductors, gas and gas storage capacity, to disruptions in supply chains and transnational energy infrastructure, to opportunistic corporate profit-seeking. Many of these factors have also been exacerbated by the tense geopolitics encircling the Russian war in Ukraine.

But fossil fuel dependency lies at the heart of the problem, especially in Europe. Unpredictable gas markets only end up affecting everyday consumer prices because electricity, heating, transport and industrial production systems remain designed around carbon-intensive energy. In the UK, for example, wholesale electricity markets set the price of power based on the most expensive fuel available to fulfil demand. This explains why UK and European electricity bills continue to reflect high volatile gas prices, rather than the cheap renewables that represent a growing proportion of power generation.

Inflation is always and everywhere a political phenomenon

Central banks have recognised that dependency on fossil fuels is a source of price and financial instability, and hence is of relevance to primary mandates. It follows from this that speeding up the energy transition will be an important part of the solution to controlling fossilflation – the role that volatile oil and gas prices are playing in inflation – and contributing to longer term price stability.

Renewable energy and heating systems have low and stable running costs and are not bound to the capricious moods of global markets. But they have large upfront costs and infrastructural lock-in effects to contend with, which will require strategic policy to resolve. Central banks do us a disservice by acting as if their policy choices will have no bearing upon the structural economic transformation needed to achieve net-zero goals.

Indeed, promising recent progress in green central banking is now being quietly put to one side. The Bank of England’s plans to decarbonise its asset purchases, for example, have been shelved as policymakers focus instead on unwinding these portfolios.

As ever, the prioritisation of monetary tightening over decarbonisation is justified by the need for central banks to remain independent from politics. But even when considering inflation alone, the notion that central banks are apolitical actors is fast stretching credulity.

European Central Bank analysis has highlighted that profit-seeking behaviour by opportunistic firms is a bigger driver of inflation than wages, but it is still committed to raising rates – despite also recognising that households are bearing the brunt of inflationary pain. Both the Federal Reserve and Bank of England governors have suggested that workers should not ask for pay increases despite pressures on living standards, but they have made no similar requests of firms raising prices to maintain profit margins.

Behind the technocratic jargon barrier of monetary policy reports lies the stark fact that raising interest rates amounts to demand destruction: a painful exercise in deliberately slowing the economy that will have unavoidable distributional consequences.

Reimagining central banking for a new era

It is curious to contrast how willing central bankers have been to embrace this inherently political inflation control strategy with the delicate hesitancy applied to greening monetary and financial policy, where “political implications” are readily used as an excuse for inaction. This is of course due to the narrow definition of their primary mandates, where two decades of independent central banking has normalised the technocratic deployment of interest rate policy in isolation of its political ramifications.

Yet central banks now find themselves in the extraordinary situation of being bound to a policy tool that will exacerbate the cost-of-living crisis and delay the green transition, as well as being largely ineffective against the supply-side drivers of inflation. To preserve their credibility as macroeconomic policymakers, central banks and finance ministries need to embrace and encourage productive discussion on policy alternatives that may be more appropriate under the current circumstances.

Alternative proposals for inflation control have emphasised the need for coordination across different public institutions. Governments could levy windfall taxes to prevent price-gouging and regulate essential prices such as energy bills. Financial regulation could keep financial services accessible and affordable for those most in need. And a dual interest rate policy could ensure that rate hikes do not inadvertently derail the green transition by offering a preferential discount rate for green lending.

Above all, we need to be recognising that progress towards green transition goals is the ultimate indicator of future macroeconomic and financial stability. Central banks should more openly consider how their powerful policy toolkits can align with and support the goals of long-term strategic green industrial strategy.

It is often said that, when given a hammer, everything looks like a nail – an adage that unfortunately sums up the current consensus on inflation control. Yet not only do central banks have far more tools in their arsenal than rate hikes, but they should recognise that monetary policy cannot be seen as isolated from the cost-of-living crisis and the energy transition.

If recent events are anything to go by, the coming energy transition is likely to be difficult and disorderly. It is time to reimagine how monetary policy, and central banks more broadly, can be redesigned to address the challenges ahead.