Climate risk is increasingly relevant for monetary policy, BoE director says

While it might not be the job of central bankers to fight climate change, the topic is becoming more important for monetary policy as droughts and floods hit economic growth and trigger inflation, according to a director at the Bank of England (BoE).

“If climate change – or the policies enacted to mitigate it – affect economic outcomes, it is a relevant consideration for monetary policy makers just like any other economic shock,” James Talbot, an executive director at the Bank of England said in a speech last week.

Talbot, who is also chair of the Network for Greening the Financial System’s (NGFS) workstream on monetary policy, said policy makers usually take account of shocks that could happen in the next two to three years, especially those which push inflation and output in different directions.

“There is evidence that the impact of climate change is increasingly exhibiting these characteristics,” he said. “Different central banks have different mandates, but if climate is a macro-relevant shock over the monetary policy horizon, then central banks will need to understand it.

“While their impact will vary, these shocks may look similar to those that monetary policy makers have faced in recent years – large, unpredictable and potentially persistent, supply shocks. In other words, they may increasingly present difficult inflation-output trade-offs for policymakers to manage.”

Talbot said this did not mean central banks should use monetary policy to encourage the climate transition. He said that was a job for government policy, adding that the best contribution monetary policy can make is to ensure economic stability.

“As acute physical shocks occur more frequently, monetary policymakers will need to understand the economic impact of these shocks and may need to react to them in order to keep inflation expectations anchored,” he said.

Climate advocates have long pushed the idea of a dual interest rate for green financing, especially as rate rises to combat inflation in recent years have increased the costs of renewables which have higher upfront costs.

Talbot noted that government policies to fight climate change were also likely to have a bigger impact on monetary policy, particularly due to expanded carbon pricing.

“Carbon price rises could exert more ‘direct’ upward pressure on headline inflation,” he said. “Bank analysis suggests that climate transition policies were probably more important contributors to recent movements in inflation than we previously thought.”

He said some central banks have already embedded climate-related variables in their forecasting methods for GDP and inflation and said the BoE is exploring how climate change impacts can be integrated into monetary policy decision-making, including via a modelling collaboration with the IMF and more systematic use of scenarios.

“Although the climate transition might seem like a problem for monetary policy to deal with, delaying it will only accrue greater difficulties for monetary policy further down the road,” he said.

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