Climate shocks may force monetary policy rethink, says World Bank’s chief economist

Economic shocks resulting from climate change and the green transition could force central banks to reassess their inflation targets, the World Bank’s chief economist has said. His warning came alongside a call for central banks to help catalyse financial flows towards reducing the carbon footprint of “dirty” sectors as well as supporting purely “green” ones.

Ayhan Kose said shocks could occur on both the demand and supply sides, and could prove persistent, in which case central banks would have to alter their monetary policy frameworks. Speaking at a panel discussion as part of a conference hosted by the Bank of Thailand, he called for central banks to use climate scenarios to determine what monetary policy challenges could arise.

His concerns were echoed by Francois Villeroy de Galhau, governor of the Bank of France and European Central Bank (ECB) board member, who suggested that the impact of climate change could lead to stagflation. He said that while central banks may be tempted to “look through” green transition-linked inflation, this would be a risky path, and they would have to “react but not overreact”.

Although central bank officials stress the uncertainty over how the green transition may affect prices in the medium term, there is a broad consensus that the long term shift to renewables should ultimately help to slow inflation.

Economists, including the head of the ECB’s climate centre, wrote in a recent blog post that “for central banks globally, fighting climate change and fighting inflation can go hand in hand”. The authors also acknowledged that “the overall impact of the green transition on inflation is highly uncertain and depends on many factors, including the climate actions taken and the policy responses made”.

ECB president Christine Lagarde has placed climate change within the central bank’s price stability mandate and called for it to be fully incorporated into monetary policy.

Kose also spoke about the ways in which multilateral development banks (MDBs) can work with central banks to promote climate action. He listed “analytical work, advisory work, operations, convening power and lending” as some of the roles they can fulfil.

A deal struck at the UN Cop27 climate summit called for rapid and far-reaching changes to the world’s financial system to fund the transition to a low-carbon economy, with central banks listed as one of the actors that should be engaged in the process.

Speaking at the Bank of Thailand conference, Ravi Menon, chair of the Network for Greening the Financial System, said policymakers must avoid taking an “overly simplistic view” towards the role of the financial sector in the green transition. He warned against an excessive focus on supporting “purely-green” sectors at the expense of incentivising polluting firms to reduce their carbon content.

“Derisking high-carbon sectors and investing in green won’t get us to net zero,” he said.

Menon said that purely green sectors account for only 8% of the global economy, whereas steel, plastic, cement and ammonia account for 17%. He said such sectors are currently high-carbon, but are critical to the functioning of the global economy.