Central banks must stop ignoring climate change

Synopsis: Ignoring climate risks will complicate macroeconomic management, just as overlooking financial risks eventually led to the global financial crisis.

Introduction

Economic activity, is strongly integrated with emissions that contribute to climate change. Output and Greenhouse gases (GHGs) go hand in hand, and will continue to do so.

After a drop in 2020 due to the great lockdown, global greenhouse gas (GHG) emissions will grow this year and, again, in 2022.

According to the International Energy Agency, 2023 is projected to be the year with the “greatest levels of carbon dioxide output in human history”.

Given the tight relationship between economic activity and emissions, central banks need to explicitly internalize the aspects of climate change that affect the output gap “block”.

What is the issue with current policies of central banks towards combating climate change?

Decades after climate change became important in public discourse, climate change-induced considerations seem to be ignored in monetary policy of central banks.

If sustainability is a defining characteristic of potential output, then it has to incorporate climate considerations.

In other words, high inflation can no longer be the only symptom of macroeconomic instability if central banks are serious about the subject. Integrated assessment models have to be explicitly incorporated in central bank work that informs monetary policy.

What needs to be done?

The following five dimensions should be taken into account:

Firstly, effect of rising temperature and climate variability on short-term economic activity stemming from, disruptions due to extreme floods;

Secondly, National commitments made in Paris are akin to an additional constraint to maximising national output consistent with climate-neutral real-economy outcomes;

Thirdly, Feedback loop from economic growth to higher GHGs;

Fourthly, Implications of rising temperatures, in the absence of requisite adaptation, on long-term economic capacity as emissions thresholds are breached, with resultant consequences for labour productivity, degradation of capital stock, and, even vitiate capability of the atmosphere to repair itself; and

Fifthly, Expected changes in carbon-related tax and subsidy arrangements.

What is the way forward?

While no single country may have an appreciable impact on total global emissions, climate change is a damaging permanent shock to potential output.

Ignoring climate risks will complicate macroeconomic management. Therefore, monetary policy will have to adjust, otherwise “conduct as usual” by central banks can undermine climate goals.

Source: This post is based on the article “Central banks must stop pussyfooting on climate” published in Business standard on 9th Sep 2021.