From Financial Stability to Price Stability in Sustainable Central Banking

June 25, 2024Published by Just Money

Central banks’ consideration of climate change through the lens of financial stability risk is preventing them from proactively addressing the threat it poses to prices, say climate economists David Barmes and Simon Dikau.

The authors consider the mounting evidence proving that climate and transition-related factors are key drivers of inflation, concluding that central banks should approach sustainability within their price stability mandates.

A purely financial risk-based approach is conceptually flawed and supports the misguided notion that climate risks are hedgeable, say the authors. This approach also supports the idea that financial stability can be achieved in an unstable climate, when these unprecedented risks are inherently unhedgeable, radical uncertainties.

However, a shift is taking place in Europe, with the price stability objective gradually displacing financial stability as the primary justification for the ECB’s green agenda, and the Federal Reserve should follow suit, the authors argue.

The article presents a typology of effects that could emerge simultaneously under various transition scenarios:

  1. inflationary pressure from physical climate change impacts, such as food inflation due to extreme weather;
  2. inflationary pressure from the green transition, for instance energy inflation due to renewable energy supply chain bottlenecks;
  3. disinflationary pressure from physical impacts, such as reduced income and wealth levels due to damage to physical capital;
  4. downward price pressures from the green transition caused by low electricity prices from reduced fossil fuel dependence.

The authors consider the implications of these complex inflationary dynamics for monetary authorities. First, they say central banks should incorporate climate factors into inflation forecasting and develop models that incorporate high levels of uncertainty and price volatility.

Second, they present a strong case for dual interest rates, targeted green lending, and climate-informed collateral policies to protect green investments from higher interest rates. Such measures have already been implemented in Bangladesh, China, South Korea and Japan and are currently being considered by the European Central Bank.

Finally, the authors argue central banks should “look through” negative supply-side shocks associated with the green transition (e.g., renewable energy supply chain bottlenecks) and refrain from hiking rates in response to such shocks. Rate hikes would not resolve supply issues and would exacerbate the primary cause of inflation – fossil fuel dependency.

Additionally, it would raise overall borrowing costs and exacerbate debt distress, particularly for countries in the global south, threatening the public investments crucial for the transition away from fossil fuels.

However, looking through supply shocks is currently not possible without the cooperation of the US Federal Reserve, given its outsized influence on global interest rates. 

“In a dollar-dominated international system, if the Fed hikes rates, central banks across the world are pressured to follow suit to avoid capital flight and currency depreciation,” the authors say.

Unless the Fed adapts its approach to incorporate climate risks into its inflation modelling and policy decisions, “major reforms to the international monetary and financial system” may be needed to achieve truly sustainable central banking and promote global price and climate stability.

While discussion of such reforms lies outside the scope of this article, the analysis implies that reforms may be required to reduce the Fed’s global price setting influence.

This page was last updated June 26, 2024

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