Climate-Conscious Monetary Policy

April 30, 2024Published by Banco de España

Delaying action on carbon taxes can create short-term tensions between price stability, social welfare and climate goals, according to this Banco de España working paper. However, climate-conscious quantitative easing (QE) can be used to help align core monetary and climate objectives while maximising social welfare.

Authors Anton Nakov and Carlos Thomas used a combination of macroeconomic modelling, monetary policy tool analysis, and empirical calibration using evidence from the European Central Bank’s corporate bond purchase program to study the role of central banks in addressing climate change.

They developed a New Keynesian model to capture the imperfect substitutability between green and fossil fuel energy sources, as well as the damaging impact of climate change on future economic output. Climate externalities arise because businesses and households continue to use fossil fuels despite their impact, although governments can address this through carbon taxes.

In the scenario with optimal carbon taxes, central banks can fully offset climate externalities by implementing “full QE”. Here the central bank absorbs as many green and climate-negative bonds as needed to eliminate bond spreads and ensure market prices match socially optimal levels, all without sacrificing inflation targets.

However, the sluggish pace of carbon taxation policy so far points to the likelihood of delayed and suboptimal transition, according to the paper’s analysis.

In this “slow green” transition scenario, in which the optimal tax is phased in over 30 years, excessive fossil fuel consumption creates trade-offs as it may encourage central banks to depress output to reduce energy consumption. This would come at the cost of lowering output below the natural level and accepting temporarily lower inflation, which can adversely affect social welfare.

While the researchers find this trade-off between central bank goals of stabilising inflation and the welfare-relevant output gap would be quickly resolved in favour of price stability with only a short-lived deviation from strict inflation targeting, green QE can further minimise the impact.

During the initial phase of the slow transition when the actual carbon tax is significantly below the optimal level, the authors say the gap is too large for partial green tilting alone to implement the socially optimal fossil energy price.

In this stage, central banks should implement 100% green tilting, abstaining from purchasing any climate-negative bonds to offset the externality.

In the second phase, as taxes rise, central banks can shift to a partial green tilt, selectively buying climate-negative bonds to reach the optimal fossil energy price and compensate for any shortfall in carbon taxes. This green tilting allows central banks to accelerate the green transition, with fossil fuel use hitting the socially optimal level a year and a half earlier.

However, the authors caution that the effectiveness of green QE in curbing emissions and temperatures is “limited by the small size of eligible bonds’ spreads”.

This page was last updated April 30, 2024

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