Climate change is relevant for monetary policy. Here's why

Until very recently, climate change was not regarded as relevant for monetary policy. A key impediment was the difference in horizons, which in turn reflected a consensus that monetary policy smooths economic fluctuations around their long-run growth trajectory but does little to affect the trend itself. Climate change, in contrast, mattered over horizons spanning decades (Brunnermeier and Landau 2020).

However, the notion that climate change and monetary policy are seemingly unrelated is now being reassessed in several ways (ECB 2021). First, there is growing awareness that, after decades of procrastination, the transition is now impending. The gap between the climate change and monetary policy horizons might thus be narrowing. Second, more frequent, disruptive climate disasters are increasingly challenging the view that climate change is something for the long term. Indeed, several recent studies have documented that climate-related risks are already having an important bearing on inflation (Moessner 2022, Faccia et al. 2021, Konradt et al. 2021).

Reflecting this shifting consensus, the recent literature has highlighted three main channels through which climate change can affect monetary policy:

Thus, central banks need to assess the impacts of climate change on the economy, the inflation outlook, and financial markets. Several central banks have started to incorporate the implications of climate change into their policymaking. To support these efforts, the Network for Greening the Financial System (NGFS) has published several reports, including on climate scenarios and research priorities for the impact of climate change on central banks (NGFS 2021). The ECB has dedicated an entire workstream to climate change as part of its recent strategy review (ECB 2021).

As a source of more frequent, intense, and persistent shocks to the economy whose nature (supply and demand) will be harder to identify, climate change will complicate the assessment of the monetary policy stance. More frequent, one-sided shocks will require a more proactive stabilisation role of monetary policy. Monetary policy will also be confronted more often with the trade-off between output and inflation stabilisation.

Traditionally, central banks calibrate their response to a shock depending on its size and persistence. If the shock is assessed to be short-lived and unlikely to affect the medium-term inflation outlook relevant for monetary policy, central banks may ‘look through’ the shock. However, as climate change amplifies the frequency and severity of supply shocks making them more persistent, ‘looking through’ such shocks may become increasingly difficult for central banks. If shocks increasingly become more persistent and there are risks that they may lead to a de-anchoring of inflation expectations, monetary policy action may be warranted (Schnabel 2022).

Climate change could also make it harder to identify a monetary policy stance that is considered ‘neutral’. The natural rate of interest, r*, provides an important benchmark to assess how accommodative the monetary policy stance is given the level of the policy rate. Several risks related to climate change may imply a dampening force on r*, on top of the factors that have already driven its secular decline over the past few decades.¹ At the same time, green investments and new technologies could push r* up, all else being equal. The net effect of these two opposing forces is uncertain. But should the downward forces prevail, the lower r* would reduce the policy space for conventional monetary policy. Among other things, this would strengthen the case for non-standard measures to become part of the ordinary monetary policy toolkit.

The ECB (2021) presents some model simulations illustrating how physical and transition risks related to climate change could combine with existing financial and fiscal fragilities, which themselves could be the result of the materialisation of climate risks, and could significantly restrict the ability of monetary policy to respond to standard business cycle fluctuations.

Climate change could also bear implications for the design of the monetary policy regime. Focusing on inflation-targeting central banks, by far the most popular monetary policy regime worldwide, in Boneva et al. (2021, 2022) we consider how certain design features of this framework might interact with, and evolve in response to, the climate challenge.

Inflation-targeting central banks may re-examine the link between headline and core inflation to look through shocks when they are assessed to be temporary and do not threaten the anchoring of inflation expectations. Appropriate communication emphasising the relative stability of underlying inflation measures may underpin the case for a monetary policy stance that looks through those shocks.

The relative merits of point versus range targets may also be reconsidered. Point targets precisely communicate the policy aim of the central bank, signal the medium-term nature of the inflation objective, and anchor expectations. Range targets, or tolerance bands, convey the sense that inflation does not need to be kept at a specific value at any point in time. They also add monetary policy space to accommodate temporary shocks to prices, thereby permitting a certain degree of output stabilisation. However, range targets may blur the precision of the inflation target and lead to less stable inflation expectations in a situation in which strong inflation shocks may increase the risk of de-anchoring.

Concerning the target horizon, as climate-related shocks impact the economy over different horizons and with different persistence, inflation-targeting central banks may need to monitor the optimal length of the monetary policy horizon. While longer target horizons can limit the decline in output and employment and mitigate their volatility, under flexible inflation targeting, the credibility of the central bank may be at risk if the time horizon is extended too far into the future and inflation misses become too frequent.

The sustained impact, especially of transition policies, on inflation volatility and trend could call for a greater emphasis on monetary policy flexibility. At the same time, as the credibility of the central bank may be questioned if the inflation target is interpreted too flexibly and inflation misses become too frequent, clear communication about the policy intentions of the central bank will be essential to mitigate credibility losses. However, given our still limited knowledge of the possible long-term implications of climate change for the economy and inflation, it is perhaps too early to derive precise implications for the design of the monetary policy strategy at this stage. These will only emerge over time.