Using Green Credit Policy to Bring Down Inflation

Monetary policy should protect clean energy investments or risk undesirable effects on price stability and inflation, say researchers. In this paper for the Grantham Research Institute, economists turn to a longstanding practice in central banking of protecting sectors which prevent, rather than cause, inflation during a tightening cycle.

The authors, Eric Monnet and Jens van ‘t Klooster, outline options for central banks to design green credit policies which address inflation while making allocative and accountable choices in support of low-carbon transition.

In recent years, climate-supporting measures have been associated with an expansionary monetary stance. However, efforts to bring down inflation in the short term by reducing green investment will have perverse long-run effects, say the authors.

First, undermining the energy transition would expose economies to stronger fossil fuel energy price shocks. Second, hindering investment in climate mitigation would make the global economy vulnerable to future climate and biodiversity-related economic shocks, jeopardising long-term price stability.

To fulfil primary mandates and fight inflation, authors say differentiated green credit policy is “necessary, justified and feasible”. They cite research showing that blanket interest rate hikes disincentivise investments in clean energy production, energy efficiency and adaptation to climate change, due to the high upfront costs needed.

Credit policies are public interventions that steer the relative price, volume and allocation of credit. Central banks can influence credit directly, through lending and credit guidance, or indirectly through price incentives.

Throughout the 1970s and 1980s, European central banks did not hesitate to protect monetarily important credit flows during interest rate hikes. The authors highlight that both the Bundesbank and Banque de France selectively exempted export credit from credit restrictions until the 1990s. This demonstrates that selective exemptions are neither new nor necessarily contrary to central bank independence.

The authors recognise that credit policy “is the domain of many more institutions besides the central bank”, and say accountability and legitimacy must be built into the design and governance of green credit policies. Green taxonomies are presented as a key tool for ensuring normative choices remain the chief domain of governments, who are better equipped to decide upon the legitimacy of such allocative policies.

The authors emphasise that the powers of policymakers and central banks should be clearly defined. They outline two possible approaches: a central bank option or a co-ordination based one. Under the first, central banks would make credit allocation decisions in line with green taxonomies and in strict relation to price stability. A coordination-based approach leaves these decisions to public bodies, such as dedicated credit councils.

The authors stress the need for transparency and independent accountability mechanisms, such as external evaluations of central bank decisions, irrespective of the approach taken.

The authors conclude by exploring appropriate instruments for implementing green credit policies. These include: lending to an investment bank or government vehicle, or creating a special status for debt guaranteed by these institutions; green refinancing credit; green asset purchase programmes; and green-tiered reserve requirements.