It’s time for central banks to stop procrastinating on the climate
After a drop in 2020 due to Covid-19, global greenhouse gas emissions will increase this year and again in 2022. It’s getting worse and worse. According to the International Energy Agency, 2023 is expected to be the year with “the highest levels of carbon dioxide production in human history”. The sixth assessment report of the Intergovernmental Panel on Climate Change explained in detail that irreversible changes in climate due to human influence are being observed around the world.
Economic activity, of virtually all kinds, is heavily integrated with the emissions that contribute to climate change, resulting in the dramatic drop in carbon emissions last year and sharp declines thereafter as production returns to its normal state. reference level. Production and GHGs go hand in hand and will continue to do so.
Central bank regulations incorporate granular climate risks from the perspective of financial intermediation and financial stability into transaction-based frameworks. At the most basic level, these regulations force intermediaries to recognize the possibility of climate risk factors that reduce the ability of borrowers to repay and service debt. This includes the likelihood that, in extreme circumstances, the collection of a loan could be compromised. Overall, this recognition translates into an appropriate (usually higher) pricing of risk to the borrower and the setting aside of more bank capital through the intermediary.
What about monetary policy?
The consequences of climate change are now apparent in many parts of the world. The gap between the increase in the stock of GHGs and their impact seems to be narrowing – important thresholds have been crossed. Remarkably, decades after climate change became prominent in public discourse, the accumulation of climate change-induced considerations seems to be overlooked in the “reaction functions” of central bank monetary policy.
The canonical economic relationships that guide changes in central bank policy rates have, for the most part, integrated the use (levels) of factors of production and changes in inflation relative to production. The Phillips curve as an empirical observation evolved into the practical or applicable Taylor rule (given below). The policy rate is mainly determined by the deviation of real inflation from the target (the latter is typically 2% to 4% for central banks targeting inflation) and the deviation of real output by relative to “potential” output, called the “output gap”.
i = 𝛱 + r * + 0.5 (𝛱 – 𝛱 *) + 0.5 (y – y *)
i is the nominal interest rate
is the inflation rate
𝛱 * is the inflation target
r * is the real neutral interest rate
y * is the potential output and
y – y * is the ubiquitous output gap.
The rule encompasses both the objectives of controlling inflation (“nominal peg”) and moderating output fluctuations of monetary policy (with the interest rate as the policy instrument). The basic idea is that, all other things being equal, inflation tends to rise when output is above potential, and conversely to fall when output is below potential. The rule emphasizes the rationale for a positive real interest rate when inflation exceeds the target and the need for positive real interest rates to manage inflationary pressures. In a flexible inflation targeting framework, the interest rate rule requires that inflation management be placed more heavily on other goals.
High inflation is the key symptom of macroeconomic unsustainability. The theoretical and empirical link between the conventionally defined output gap and inflation has historically been so strong that hardly anyone questions this description. In recent years, the concept of the financially neutral output gap to determine the policy rate has gained ground. This was in response to the 2008 financial crisis, when the increase in financial risks from 2004 was discounted by global central banks as inflation continued to be at (or below) target and that monetary policy had remained accommodative (which added to the accumulation of risk) because of negative conventional output gaps.
The financially neutral output gap assesses the sustainability of economic growth on the basis of broader financial considerations, as inflation below the prescribed target gives a false or, at least, incomplete impression of macroeconomic soundness. . It is widely accepted that in some countries, the financial crisis and its aftermath have contributed to long-term social and political contracts between voters and elected politicians, so the costs of ignoring the obvious risks can be significant, multidimensional and sustainable.
Given the close causal relationship between economic activity and emissions, it may be time for central banks to formally and rigorously internalize the aspects of climate change (and variability) that affect the “bloc” of government. the output gap in the series of models that underlie the reaction function. metric. It may not be out of place for central banks to include a report on the subject as part of policy statements.
There are five dimensions, although not entirely independent, to consider:
- Effect of rising temperatures and climate variability on short-term economic activity resulting, for example, from disturbances due to extreme flooding.
- Regulatory restrictions: the national commitments made in the Paris Agreement are similar to additional constraints to the maximization of economic production compared to the unconstrained baseline scenario. Variations between countries are significant. *
- Feedback loop from economic growth to higher GHG emissions.
- Implications of rising temperatures, in the absence of adaptation, on long-term economic capacity, as emission limits are exceeded, leading to a decline in labor productivity and a degradation of the capital stock.
- Expected changes in carbon tax and subsidy provisions.
Similar to overlooking the build-up of financial risks over the previous decade, the price will be heavy in terms of social and economic upheaval if conventional output gaps are not redefined as (neutral) output gaps widened by climate change. , or other definition and associated terminology. If sustainability is a defining characteristic of potential output, then it must incorporate climatic considerations. In other words, high inflation can no longer be an immediate symptom of macroeconomic infirmity if central banks take the matter seriously. Integrated valuation models may need to be explicitly incorporated into central bank work related to monetary policy.
While no single country can have a significant impact on total global emissions, climate change is a damaging, long-term or even permanent shock to potential output. All in all, the climate-adjusted production gaps will be smaller (less negative). Failure to take this aspect into account in the central bank’s reaction functions will lead to sub-optimal policy choices; this may mean that the current stance of monetary policy is, in theory, more flexible than it should be. No one would claim the analogy is correct, but ignoring climate risks will complicate macroeconomic management, just as ignoring financial risks led to the 2008 financial crisis.
* Estimates from “Long-Term Macroeconomic Effects of Climate Change: A Cross-Country Analysis”, IMF Working Paper, October 2019, are noteworthy. Compliance with the Paris Agreement (mitigation) is envisaged to limit temperature rise to 0.01 ° C per year and is expected to reduce global gross domestic product per capita by around 1% by the end of the century. On the other hand, the status quo, that is to say in the absence of mitigation, the reduction in real world GDP per capita is estimated at more than 7% over the same period.
Urjit Patel is President of the National Institute of Finance and Public Policy and a former Governor of the Reserve Bank of India.