Climate change and the energy transition could change monetary policy as we know it

Key points Climate change is increasingly affecting inflation and economic growth, making it a growing concern for central banks and monetary policymakers. Both climate-related disasters and the transition to a net-zero economy can create inflationary pressures and economic disruptions, potentially complicating interest rate decisions. The NGFS argues that early and orderly climate action can reduce long-term economic and financial risks, while delayed action is likely to make future adjustments more costly and disruptive. Climate change and the transition to a green economy could have implications for monetary policy, as growing climate risks could increase prices, a recent report from the Network for Greening the Financial System (NGFS) shows. The network of central banks focused on climate issues released two reports on Wednesday, looking at the potential impact of climate change and how central banks could respond in the face of such challenges. "Climate change and the transition to net zero are increasingly affecting inflation, output, and monetary policy,” said Sabine Mauderer, chair of the NGFS and first deputy governor of the Deutsche Bundesbank. James Talbot, chair of the NGFS workstream on monetary policy and executive director of the international directorate at the Bank of England, said the two reports could help central bankers address those changes. "Climate change and the transition to net zero emissions are reshaping the macroeconomy in ways that matter directly for central banks' core mandates,” he said. “Physical and transition-related impacts can affect both inflation and output, potentially generating trade-offs for monetary policymakers, particularly as physical climate shocks become more frequent, severe and persistent”. Climate change is a risk to the economy The reports support a growing body of research showing how physical climate change and transition changes are likely to have a dramatic impact on the economy, potentially leading to higher inflation . One of the NGFS reports on climate change and monetary policy strategy lays out a guide for central banks, expanding on work already completed by the coalition on the macroeconomic impacts of climate change. Physical impact from climate change could affect commodity prices and disrupt supply chains, further amplifying losses and contributing to inflation. A transition to a net zero economy could reduce output and increase inflation in the short-term, especially if a move to green technologies is not supplemented with government support of workers and impacted technologies, the NGFS says. Still, the NGFS emphasises that over the long term, the economic impact is likely to be more severe if there are no climate policies in place. “As climate-related shocks become more frequent and severe, their effects will be harder for monetary policymakers to “look through,” the report states. Climate risk could lead to inflation trade offs Climate shocks and the transition to a green economy could also create trade-offs for monetary policymakers, the NGFS says. While the NGFS recommends central banks respond just as they would to other shocks, there are aspects of climate-related shocks that are particularly challenging. Namely, duration and noticeable impact on households. Repeated physical climate shocks could be particularly challenging for central banks to manage due to compounding effects, the NGFS warned. Other chronic changes, such as rising sea levels, could erode labour and factor productivity and depreciate capital and infrastructure. The study pointed to unprecedented flooding in 2022 in Pakistan and a 2024 cyclone in Mauritius as recent examples of macroeconomic stresses caused by climate change. In Mauritius, fiscal authorities provided economic support, while the central bank focused on maintaining medium-term price stability. In contrast, the flooding in Pakistan led to a sharp increase in inflation, prompting sharp monetary tightening. [caption id="attachment_11332" align="aligncenter" width="1024"] As weather events become more extreme, it could have a lasting impact on monetary policy. Photo by: UNHCR/ R. Rocamora[/caption] Need for further assessing climate risks To determine the best monetary response, the NGFS suggests central banks should assess how such impacts on supply and demand could evolve over time. Central bankers also need to consider whether climate-related shocks are just related to price or create broader inflationary pressure, as it could warrant different monetary responses. For example, a temporary price shock due to a transition could be best dealt with no change, while a more persistent impact on inflation could warrant a tightening in monetary policy. Other factors could have varying levels of impact on inflation, for example, the magnitude, duration, location, or predictability of such climate shocks. “More frequent and severe climate-related shocks may qualitatively change monetary policy strategy and frameworks,” the report states. The report also noted that there are various uncertainties related to data and modelling. Because of the nature of climate change and uncertainty around its future impacts, traditional economic models used by central banks can not account for certain factors, such as climate tipping points . Climate change vs central bank mandates While NGFS chair Mauderer stressed that central banks don’t set climate policy, she noted it was important that they understand and respond “within their mandates”. The reports, she hopes, will help central banks better understand such climate risks. “The message is clear: an early, orderly, and credible transition can help limit macroeconomic and financial risks, while delay would make the adjustment more costly and more disruptive”. One of the core discussions among central bankers and campaigners is whether mitigating climate change risk is part of their mandates or is instead the role of governments. While the European Central Bank (ECB) has stated that it sees climate change risk as a core risk to inflation and part of its secondary mandate of furthering the policies of the European Union, others have argued that green policies fall outside of supervisors’ purview. The NGFS outlines that while the tools and responsibility of setting climate policies lie within governments, it’s up to central banks to respond to the potential economic impacts. “Monetary policymakers should respond to climate-related shocks as they would to any other relevant shock: by assessing the expected impacts on inflation and output over time,” the report states. It also comes down to data and communication, with the NGFS recommending that central banks clearly communicate their role in relation to the transition, acknowledge the complexity, and tailor their communications to stakeholders to ensure clarity. The post Climate change and the energy transition could change monetary policy as we know it appeared first on Green Central Banking .