The Effects of Climate Change on the Natural Rate of Interest

A recent working paper from the European Central Bank (ECB) projects a likely “dampening effect” of climate change on the natural rate of interest (r*), potentially creating substantial issues for monetary policymakers. By contrast, orderly transition policies were simulated to mitigate the impact on r* and provide more room for monetary policymaking. The authors recommend central banks should address carbon biases in order to fulfil their  mandates.

The paper defines r* as the interest rate that “allows the economy to operate at its potential” while “keeping inflation at its target”. While r* is abstract and cannot be directly observed, it is a vital benchmark for central banks, and downward trending r* reduces policymakers’ options. Once r* reaches the effective lower bound (ELB), conventional monetary policy becomes ineffective for stimulating GDP.

The paper’s systematic review, which combines central bank and climate economy modelling, concludes that climate-related damages and uncertainty will likely place downward pressure on r* by reducing productivity growth and increasing precautionary savings. 

The paper also states that even accommodative monetary policy may contribute to reductions in GDP if it contains carbon biases. For instance, the concept of “market neutrality” in the ECB’s asset purchasing programmes, which creates favourable financing conditions for carbon assets, may increase downwards pressures on r* and the risk of hitting the ELB.

The authors emphasise that the impact of climate change on monetary policy “cannot be ignored”, and that restoring the desired relationship between policy and GDP requires “proactive” integration of climate concerns into the ECB’s modelling and policy frameworks. 

They also recommend adequate carbon pricing and targeted financing schemes for innovative green projects, as well as increased flexibility in the ECB’s monetary policy objectives and time horizons, given the uncertain and variable impact across the eurozone.

The paper finds climate change is likely to cause damage to capital stocks, labour productivity, agricultural yields and industrial output, as well as fundamental uncertainty, risk aversion and income inequality. It is also likely to lead to substantial damage to investment flows, higher equity risk premia and downwards pressure on bond yields. With trends increasing exponentially in scenarios involving tipping points from temperature increases above 3-4°C. 

Scenarios in which transition is poorly managed or delayed were also found to elevate risk aversion and uncertainty, amplifying potential disruptions to energy and commodities. As well as increasing rates of capital depreciation, stranded assets and damage to capital stock.

However, the authors argue an orderly transition may mitigate this impact. When simulating an orderly transition in the eurozone, innovations and investments associated with transition were largely found to mitigate climate damage and support steady investment flows.

The authors argue that effective fiscal policy and carbon revenue recycling are the most obvious and effective ways to decarbonise economies and avoid hitting the ELB. Particularly if funds are reinvested into sustainable infrastructure, innovative projects, research and development, and adaptation and mitigation funds.