The bushfires raging in Australia are a graphic illustration of the climate emergency that seems certain to dominate global political debates in the next decade. However, macroeconomists and central bankers have been slow to focus on the new issues that climate change will bring to their policy deliberations. This is changing rapidly.
There are essentially three areas that central bankers need to address:
Progress has been substantial on the first issue, but much less on the other two.
There is now a consensus among central banks that the growing risks to financial stability must be addressed urgently. Mark Carney, in his twin roles of governor of the Bank of England and former chairman of the G20’s Financial Stability Board, has been the world leader in encouraging corporations to measure, publish and address climate risks, backed by stress tests. He is soon to leave the BoE but fortunately, he now moves on to become UN envoy on these issues.
By improving the quality of information on the effects of climate change, Mr Carney hopes to avoid a “Minsky moment”, akin to the subprime mortgage collapse in 2008, when complacent markets suddenly recognised the scale of hidden risks embedded in asset prices.
About 50 central banks have now joined the NGFS, the central banks’ network focused on climate change risk management. The Federal Reserve has declined to participate, but is realising that this position will not be tenable for much longer.
On monetary policy, however, there is less consensus, and a clear divide is emerging between the Fed and the European Central Bank.
Last November, Fed chairman Jay Powell told a congressional committee that climate change is not a “near-term threat”, and is not something the Fed is considering “right now”. The Fed’s leadership believes the effects of climate change on GDP growth and inflation — as distinct from its effects on the natural environment — will be negligible in the near term, and of uncertain size in the very long term (see below). Climate change is therefore hardly mentioned in Federal Open Market Committee monetary policy deliberations.
Nor does the Fed accept that the management of the US central bank’s balance sheet has any direct responsibility for mitigating global warming. A paper by Glenn D Rudebusch of the Reserve Bank of San Francisco in March 2019 explicitly rejected the purchase of “green bonds”, because the Fed’s mandate allows it to purchase nothing other than government, or government agency, paper. Under President Donald Trump, no government entity will issue green bonds.
Any attempt by the Fed to extend its mandate into the sphere of climate policy would be extremely controversial in both the White House and the Senate. This is a battle the central bank is choosing not to fight.
The ECB’s thinking is very different. This has been true for years but the gap will widen further under the new ECB president, Christine Lagarde. She says that climate change policy is “mission critical” for her term.
On monetary policy, Ms Lagarde has said that the impact of climate change on the eurozone economy could be included in the ECB’s formal economic models and assessments. These may encompass near-term growth and inflation, and longer-term effects on productivity growth and equilibrium policy rates. Climate change will move towards the centre stage of regular policy debates on the bank’s governing council.
The ECB is also far more concerned than the Fed about the potential impact of extreme weather events on global commodity prices and migration from north Africa into the eurozone in the fairly near future.
In a far-sighted speech in November 2018, former ECB board member Benoît Cœuré warned that extreme weather shocks were likely to become more frequent, with more pervasive effects on commodity prices and inflation. Mr Cœuré argued that the ECB could no longer remain passive in the face of these supply shocks.
Even more importantly, the ECB is ready to consider adjusting its asset holdings to include more green bonds. This could promote the growth of green financial markets and reduce the cost of capital for investments in clean energy, relative to carbon-based energy.
This type of proactive policy to mitigate the climate problem is considered by some (including Bundesbank president Jens Weidmann) to be outside the mandate of a central bank. However, Ms Lagarde has argued that the ECB is empowered under the EU treaties to support the broad economic strategy of the Union, including the need to mitigate climate change. She is determined to make progress.
So while central banks will never be at the centre of climate policy, the economic consequences of climate change will soon have a significant impact on their monetary policy decisions. And the composition of their asset holdings can help to alleviate the problem, especially through signalling the need for greater action across the entire financial sector.
The Fed is lagging behind the ECB on these issues. Under a Democratic US administration, that would rapidly need to change.
According to a recent paper by James H. Stock at Harvard University, global warming has passed the 1C threshold and is rising steadily.
Researchers at the Richmond Fed estimate that US GDP growth might be damaged by 0.2-0.5 per cent a year from 2070-99, with much higher effects being within the margin of error in a bad scenario for the climate. The Fed thinks these effects are too remote to affect policy today.
Source: This note is based on material which appeared in an article by Gavyn Davies published in the Financial Times on 12 January 2020.
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