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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is a former professor of economics and senior adviser at the Bank of England
Climate change has happened, it was caused by humans, and it’s going to carry on. Mean temperatures have risen, and are going to carry on rising. This means a greater probability of weather extremes.
The main policy priority in response should be to green our power generation and the rest of our industrial lives, and persuade the rest of the world to follow. It’s of much less concern how it affects central banking; but it is affecting central banking and will do so more and more.
One effect is that as we invest in greening our power, industrial processes and our food supply, we have to divert resources out of consumption and into investment. This will bid up real interest rates to encourage the switch. And central bank rates will rise to accommodate it.
Along the transition path, and perhaps at its end point, we may feel poorer than if we had done nothing, devoting more of what we earn to adapt to the new climate and prevent further change. To steer a shift towards investment by lowering consumption, central banks might find themselves achieving that via higher inflation — eroding real wages with higher prices, rather than forcing nominal wages down through a recession and unemployment.
Of course, the whole point of forcing the transition is that our more distant futures are much less impoverished. But what we will feel initially is more scarcity, not less, and central bank policies will reflect that.
The extreme weather events will disrupt work and life, causing temporary shortages and dislocation. These periods will look a bit like now, where the war in Ukraine reduced the supply of food and energy. We will see bouts of higher inflation that central banks are forced to look through, unable to respond quickly enough to do anything about them.
This extra volatility generates more risk for the economy and for banks, insurance companies and other intermediaries exposed to it. At the moment this kind of risk does not seem likely to be systemic yet for western Europe, but it could be in the US, Canada or Australia — areas already prone to extreme weather. And European financials may be exposed enough indirectly. The extra risks will raise the cost of finance as those exposed protect themselves, coaxed along by regulators who will worry that the private sector is relying on the state to cap those prospects.
This extra risk as the earth warms will drive the price of risky assets down and so-called “risk free” bonds higher. For those sovereigns that have enough fiscal space to handle climate problems, this will look like a reduction in their cost of finance at the expense of the private sector, and more fragile states.
The transition itself ought not to be a risk for lenders. Policy has been slow moving and changes are usually telegraphed far in advance. Banks ought to be able to manage a slow process of shifting lending out of carbon intensive businesses or fossil fuels, and into greener things. Market-based finance should be able to navigate the same gradual path. But there could be sudden changes in political sentiment and policy in areas such as carbon taxes and allowable activities, perhaps triggered by natural disasters. This would expose financial intermediaries if policy was not joined up.
Pressure has resulted in mention of climate change objectives in central bank mandates to get central banks to help with transition. But the green transition should be forced through by governments with carbon taxes and/or outright bans on activities that harm the climate.
Tilting purchases in quantitative easing programmes towards “green” bonds is no more than a symbolic act — the UK bought less than £20bn corporate bonds out of a total of £895bn in its QE operations — and complicates monetary policy. Adding climate criteria to bank regulations also makes financial stability policy more complex and would be redundant with the right taxes. Pulling these levers is better than doing nothing at all. But not much.
If we do nothing else, we will head towards climate chaos and not notice that we only tweaked central bank tools. There is also a risk that delegating climate matters to central banks generates complacency, convincing people that the hard decisions have been taken, when the opposite is the case.
The more jobs we give to central banks, the more they are likely to conflict, and the harder it is to hold them to account. The best toolkit for the green transition is a simple, old-fashioned mandate, and forceful government action to either tax or replace carbon intensive activities with climate-friendly ones.
Source: Economy - ft.com
