Aurelia Butler

There is a concept in the social sciences — including economics — that policymakers and those who advise them would do well to bear in mind: observational equivalence. This is when several rival explanations of what is going on are compatible with everything we are able to observe. In such cases, basing policy on a theory that fits the data (until it suddenly doesn’t) runs the risk of some nasty surprises for which we are unprepared if we don’t pay sufficient respect to the possibility that a rival explanation is the correct one.This came to mind as I was following the European Central Bank’s top central bankers’ retreat at Sintra in Portugal last week. It took place at an exquisitely difficult time for central bankers, when overall inflation is falling quite rapidly but remains too high for comfort. Uncertainty was the name of the game at Sintra — uncertainty about how fast inflation will decline, how much effect on economic activity is still to come from the interest rate rises we have already seen, and as a result, what is the right policy to pursue now.Despite acknowledging these deep uncertainties, however, the central bankers were keen to project certainty about their policy. The general message was that inflation is proving persistent, so don’t expect a softening of monetary policy any time soon — indeed, rates may have to go higher and stay there for longer than people expect. Bank of England governor Andrew Bailey, for example, commented: “I’ve always been interested that markets think that the peak will be shortlived in a world [where] we’re dealing with more persistent inflation.”There is a puzzle here. How does rising uncertainty make policymakers more, rather than less, determined? Before Sintra, Adam Tooze analysed how accepting relative ignorance shapes the new logic of inflation-fighting in counter-intuitive ways. Tooze was responding directly to a speech given on June 19 by Isabel Schnabel, an influential member of the ECB’s executive board, in which she argued that “if inflation persistence is uncertain, risk management considerations speak in favour of a tighter monetary policy stance”. The notion that greater uncertainty justifies tighter monetary policy is an argument Schnabel has been developing for some time, and this intellectual work is as good an explanation as any for the stance most central bankers have adopted.Central bankers are now openly distrusting their own forecasts. Schnabel draws on research showing that forecast errors are correlated to suggest that she and her colleagues are more likely to underestimate than overestimate inflationary pressures, since they already did so last year. That is one reason given for redoubling efforts on tight monetary policy. The other is a belief that it is easier to correct a stance that proves excessively tight than to undo the damage of doing too little to push inflation down. But as Tooze argues, whether this is the case surely depends on what the costs of excessive tightening would be. I would add that the whole argument for “robustness” also depends on what precisely the counterfactual to inflation persistence is. Any “relative cost of getting it wrong” analysis hinges on what precisely “getting it wrong” means. Supporters of tightening should therefore give serious consideration to the explanation of inflation that most undermines their position.That account is this: inflation is at present coming down by itself; not because of monetary tightening but because the supply shocks that pushed up prices in the first place have been going into reverse. By also reversing any original deterioration in the terms of trade (the additional external deficit in economies that are net energy importers), that makes it possible to restore initial real wage levels. Monetary tightening, meanwhile, affects real economic activity with a lag and has yet to affect price formation much. So the tightening comes too late to do any good, and will only add to (downward) price instability once inflation has returned to target by itself.Suspend, for the moment, your judgment of whether this is probable; focus on the fact that it is possible. The behaviour of prices is compatible with this explanation. The last big supply-side shock was the big jump in global (and especially European) wholesale energy and food commodity prices from February to June last year. Year-on-year inflation peaked that June in the US, and in October 2022 in the eurozone, in the UK and in the OECD as a whole — all but three of whose members saw inflation fall last month. Wages are still catching up with past inflation rather than leading it.It is true, of course, that “non-core” inflation (prices excluding food and energy) and services inflation (which is more domestically generated) are coming down more slowly than central banks had hoped for. In addition, inflation expectations are a little bit higher than before: in the eurozone surveys find that people at present typically expect inflation at 2.5 per cent three years from now.But this is why observational equivalence matters. As I described a few weeks ago, there is solid analysis that can account for virtually all the behaviour of both US and eurozone inflation as just what the temporary repercussions from sector to sector of a series of large supply shocks would look like. Expectations data, too, fits the possibility that people’s expectations are shaped by the inflation they currently see, so that as headline inflation keeps falling, so will expectations. In the US, inflation expectation estimations that followed current inflation on the way up have followed it in lockstep back down from the peak. The Federal Reserve Bank of Cleveland’s inflation expectations measure is now below or at the 2 per cent target for all time horizons.

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So consider what else would be true if this is in fact the true explanation of events. One implication for central banks is particularly significant: that there was nothing monetary policy could have done to prevent the bursts in inflation of the past two years, and that current monetary policy is contributing nothing to inflation coming back down. This does not mean interest rate rises have no effect, but that the effects will be exclusively harmful, because they will depress the economy — killing income and jobs growth — when inflation has already disappeared. Put simply, if this is the right explanation of the data we see, the only thing central banks are able to do is to make things worse. We can expect several retorts to this reasoning. One is that even if there was nothing central banks could do to reduce inflation in the relevant timeframe, they must still act as if they can in order to prevent expectations from drifting up. But the hypothesis to be addressed is that they cannot even do this (again, in the relevant timeframe, after which it will be counter-productive). Another retort is that even if central banks can’t do anything about a burst of inflation until it has come and gone, they can bring inflation down below target for a while after that — and it would reinforce on-target inflation expectations if people thought any high-inflation period would be followed by a depressed, low-inflation or even deflationary one, courtesy of central banks. But this would be saying that central banks should amplify fluctuations in inflation — quite the opposite, one should think, of pursuing price stability.The case for “getting the job done” in terms of tightening, therefore, has to come down to the improbability of this explanation being correct. But what do you base this on in the case of observational equivalence? Presumably by being actively on the lookout for data that is able to “break the tie” between alternative explanations. (For example, compare the sector-to-sector transmission of both price increases and price falls.) And presumably not by taking for granted the explanation that tightening came too late but is now working, and that the question is simply how much more of the right medicine to apply.An inflation hawk may be tempted to argue that since a central bank’s exclusive job is to ensure stable prices, all this doesn’t matter: it should just do all it can to lower inflation. But this is wrong in the case of central banks that have dual or mixed mandates, including the ECB for which inflation takes absolute priority. For if tightening does not have an effect on the current inflationary episode at all, then the policy should be judged on how it helps — or, rather, how it harms — its secondary mandate of supporting the EU’s other economic policies. Besides, price stability, of course, requires avoiding below-target outcomes as much as above-target ones.Accepting there is nothing you can do is hard for any policymaker. But “do no harm” is also a useful principle. Other readablesThe path to economic security for the EU goes through building a big and growing green-tech market right at home.The Bank for International Settlements has long been at the forefront of imagining how to make the monetary system fit for the future. Its latest report makes an important recommendation for a new type of monetary infrastructure: a “unified ledger” that would allow decentralised “tokens” or digitised financial claims to be connected to one another via central bank digital currencies. As the BIS puts it, this “opens the way for entirely new types of economic arrangement that are impossible today due to incentive and informational frictions”.Toyota has made tantalising promises about its solid-state battery technology; my colleague Leo Lewis kicks the tyres.Ukraine urges other countries to follow the EU’s longer-term funding pledge.Numbers newsUK interest rates are hitting record highs and so it seems is the nominal wage growth that is moderating elsewhere. Unlike other economies, the UK may well be at risk of a price-wage spiral. More

Good morning. Thanks for the heap of responses to yesterday’s letter. Readers’ views, as you will see below, fit pretty well with the Federal Reserve’s latest meeting minutes, released on Wednesday. Fed staff economists are forecasting “a mild recession starting later this year”, but with a whopper of a caveat. Narrowly avoiding a recession, Fed economists think, is “almost as likely as the mild-recession baseline”. A resigned shrug, in other words, delivered with a side order of optimism. Email us: [email protected] and [email protected]. Readers’ views of the year to comeYesterday we asked readers for views about the economy 12 months from today, by assigning a probability distribution to this matrix:

This was a slightly updated version of a matrix we added a year ago (back then, the X-axis queried the future fed funds rate, not core inflation, but the general thrust was the same). And while opinions are spread quite evenly over the four outcomes, indicating uncertainty, it is notable that over the intervening year, Unhedged’s readers have become less concerned about recession. They put the chances of one at 55 per cent, against our 60 per cent; a year ago we’d both agreed that the odds of a recession were two in three. As for high inflation, readers trimmed their odds from 45 per cent to 40 per cent:Readers have also tempered their fears about the worst-case scenario — stagflation. Readers cut by 10 percentage points the chance of entrenched inflation and a recession in the next 12 months, with opinion significantly more concentrated than last year (ie, there was a lower standard deviation among responses). With inflation’s peak in the rear-view, that makes sense, too.In all, then, respondents have a slightly more benign view of things than they did a year ago (40 came back with a complete set of probabilities that added up to 100 per cent; many others wrote to stump for one outcome or another as most likely). This is not surprising, in that inflation has eased recently while growth has hung in there.Our readers are a bit more optimistic than we are. We defer to their wisdom, and hope that they are right. If you believe in a soft landing, buy (some) small-capsUnhedged has never put high odds on a soft landing, for the simple reason that monetary policy is not surgical. It lowers inflation by hurting growth, and that is a very easy thing to overdo. We still believe that. But as more resilient economic data rolls in, we have to admit that the probability of a soft landing is rising.One vision of soft landing, advanced most notably by Fed governor Christopher Waller, revolves around the Beveridge curve, an economic model tying the job vacancy rate to unemployment. The pandemic transformed the Beveridge curve; as Help Wanted signs went up across the US, the vacancy rate soared. The yellow line below shows the Beveridge curve immediately after the pandemic struck, while the blue line shows the two decades before Covid. Notice that for any given level of unemployment, pandemic-era vacancy rates along the yellow line are higher than the blue baseline (chart from Morgan Stanley):

Waller’s soft-landing idea, illustrated with the green triangles above, is that vacancies might fall with only a modest increase in unemployment. Such a gentle reversion to pre-Covid norms would defy the historical record, but it could happen. The US has a structural labour shortage, and if employers keep gobbling up workers, you can’t have a recession. As Jay Powell put it at his May press conference: “It’s possible that this time is really different. And the reason is, there’s just so much excess demand, really, in the labour market.”To repeat, we are sceptical. Excess labour demand means steady wage growth, which puts a floor under consumption and therefore inflation. Stubborn inflation will egg on the Fed to raise rates higher, bringing down inflation by engineering a recession. But so far, sceptics like us are stuck talking about a scary future, rather than the scary present. The Beveridge curve has moved in the direction of the soft-landing believers. And investors seem newly eager to buy on good economic news. Twice last week, resilient economic data pushed up stocks and tightened investment grade credit spreads. This, points out Yuri Seliger of Bank of America, is unlike the string of strong economic data in February, which saw wider (ie, bearish) IG spreads and falling stocks. The market sees a less painful growth/inflation trade-off than it once did. So for investors on the hunt for a trade, here’s one: small-caps. The case for them starts with valuations. The S&P 500 is expensive no matter how you cut it. But not the humble Russell 2000. Valuations for this small-cap index are better assessed by price/book ratio than standard forward p/e, Goldman Sachs analysts argue in a recent note, pointing out that smaller companies may not be profitable or have reliable analyst earnings forecasts. On a p/b basis, then, the Russell looks reasonably priced:Next, consider the biggest risk to small-caps: the business cycle. Compared to large-caps, small-caps’ weaker balance sheets and more volatile revenues expose them to cyclical vicissitudes. Traditionally, that has meant small-caps sag late into a cycle, when investors flee to quality, and then rebound once recession draws to an end. The chart below shows the ratio between the S&P 500 and Russell 2000, where a rising line means small-cap outperformance. Early cycle is when you want to own the Russell:Small-caps currently labour under a discount driven by recession anxiety. The bet is that if that doesn’t happen, and it turns out we are not late in the cycle after all, the discount should dissipate.Even in a soft landing, there are risks to small-caps. One is that rates stay higher for longer. No recession means no reason to cut rates, and nearly a third of Russell 2000 debt is floating rate (versus 6 per cent for the S&P), notes Goldman. Higher debt costs would pinch small-caps’ thinner margins, denting performance. Another risk is sector composition. Todd Sohn of Strategas points out that “boom or bust biotech” is also over-represented in the Russell, and looks mired in a bust phase. Also, investors might want to think carefully before owning small-cap banks right now, and they make up 7 per cent of the Russell but only 3 per cent of the S&P.Both of these problems could be ameliorated by not buying the whole index — say by picking a basket of low-leverage stocks, avoiding biotech and banks. Sohn suggests tilting towards small-cap industrials, the largest sector in the Russell and one chiefly exposed to growth. (Ethan Wu)One good readFrom the Eurasian department of mutual incomprehension. More

Big asset managers are flocking to Latin American bonds and currencies, attracted by the region’s high interest rates, low inflation and more resilient economies than many had expected. Latin America is home to five of the world’s top eight performing currencies this year, which have benefited from the region’s central banks acting early and decisively by raising rates and keeping them high even as inflation recedes. Total returns of local bonds have also surged ahead of their developed market peers, as chunky inflation-adjusted yields draw the attention of investors. “With every month that passes the real yield is getting bigger and bigger,” said Paul Greer, emerging markets debt and FX portfolio manager at Fidelity. “So more and more investors want to put their money into Latin American currencies for that reason.”Greer, whose portfolio is overweight in local currency bonds in Brazil, Mexico, Colombia, Peru and Uruguay, said that for both government debt and pure currency exposure, Latin America is “the place to be”. An exception, he said, was Argentina, which has been cut off from access to international markets after a debt default and where inflation runs at more than 100 per cent. Latin American central banks took the fastest and most decisive action globally when inflationary pressures picked up in the wake of the coronavirus pandemic, which helped suppress price growth much more quickly than in other regions.But high rates have not choked off economic growth. Brazil and Mexico — the region’s two largest economies by GDP and the most popular among international investors — both outperformed growth forecasts in the first quarter of this year, prompting economists to raise their projections for the end of the year. In Brazil, the poster child for early and aggressive rises, annual inflation is now under 4 per cent, down from more than 13 per cent this time last year, while interest rates have been kept high at 13.75 per cent since August 2022. In Mexico, rates have been held at 11.25 per cent since March with headline inflation falling to 6 per cent in May. “In places like Brazil or Mexico, now you’re talking 6 per cent and 4 per cent real yields, based on where inflation expectations are, which is a really compelling argument to be adding to those currencies,” said Iain Stealey, chief investment officer of global fixed income at JPMorgan Asset Management.“Is it a crowded trade? Has everyone piled into it? I don’t think that’s the case yet,” Stealey said, adding foreign ownership of local emerging market bonds is still low following the pandemic and multi-asset investors “haven’t yet moved into emerging market debt”.Part of the reason investors are being drawn back to Latin America is that market nerves over leftwing governments in Brazil, Chile, Colombia and Peru have been calmed by a lack of congressional majorities that have left them unable to implement many of their policies.And central banks have maintained their independence, ignoring calls from President Luiz Inácio Lula da Silva in Brazil and President Andrés Manuel López Obrador in Mexico to cut interest rates, arguing that it stifles economic growth.“Despite all the bluster from the politicians, it has not impacted central bank decisions,” said Geoffrey Yu, senior foreign exchange strategist at BNY Mellon.Yu said another reason for the success of Latin American currencies and bonds in 2023 was years of foreign investors avoiding the region. “There’s been practically no positioning — so it’s an easy trade. It’s a good time to buy bonds before central banks start cutting rates.”The worry for currency investors now is that the rally will run out of steam as central banks start cutting rates ahead of other regions. Chile is poised to start lowering this month, investors say, followed by Peru and Brazil in August and Colombia and Mexico by the end of the year.Daniel Ivascyn, chief investment officer at Pimco, said: “At these levels we have a little less conviction on the [Mexican] peso, which has had a combination of very strong performance and relatively low volatility.”But he said bonds in Mexico and Brazil “are starting to look interesting” as inflation pulls back and the prospect of rate cuts draws closer. “They understand the cost of being late on inflation. At least the opportunity for more sustained performance is there,” he said.While some investors say the Mexican peso is starting to look overvalued, if central banks cut rates slowly, currencies across the region could continue to perform well. Greer said he is still betting in the major South American currencies because “inflation will continue to fall faster than central banks will dare to cut interest rates”.Mexico in particular has some attractive long-term structural advantages, as key beneficiary of “friendshoring” of US companies out of China to lower-cost, closer labour markets, and a surge in remittances boosted by a tight US labour market. It also has among the most stable finances in the region, boosted by fiscal restraint in response to the pandemic, but is one of the most sensitive emerging markets to any slowing in the US economy. Despite the risks, Jim Cielinski, global head of fixed income at Janus Henderson, said emerging and developing markets in general “look much better positioned in aggregate than their developed market peers”.“We would expect the Mexican peso and Brazilian real to be higher by the end of the year,” he said. More

India’s top trade official said that talks with the UK on a trade agreement were “moving very well” and downplayed remaining hurdles on easing temporary work visas for Indians and opening up industries including automotive and spirits. Piyush Goyal, minister of commerce and industry, also said that India was pushing for transition periods or more market access in some sectors because its economy, currently slightly larger than the UK’s, would far outgrow it in the decades to come. “There are one or two areas that were a little slow and we are speeding that up,” Goyal said in an interview with the Financial Times. He added that he had spoken to his UK counterpart, Kemi Badenoch, on Tuesday, “and my own sense is that we will see a good outcome soon”. The proposed trade deal would be one of the most significant concluded by Britain since it left the EU. It would also be significant for India, which last year overtook the UK as the world’s fifth-largest economy and, according to some forecasts, could surpass Germany and Japan to become the third-largest by 2030. “India will grow from a $3.5tn economy to $35tn,” Goyal said, referring to a target he has said India should aim for by 2047, its centenary of independence. “But with a small population, largely satisfied, what would the UK economy be 25 years from now?” Officials and diplomats in India have speculated that talks on the proposed trade deal might be concluded by early September, when India will host a G20 summit in New Delhi. Both sides have already missed an agreed deadline of October last year to finalise the deal. Goyal would not be drawn on a new target date for wrapping up the talks but said there was “nothing which is a deal-breaker” remaining between the sides. “I’ve given a good deal on Scotch whisky, I’ve given a good deal on automotive,” Goyal said. “We have been very, very open.”Nigel Huddleston, UK minister of state for international trade, is currently in India meeting businesspeople to discuss the potential merits of a trade agreement, according to two people briefed on his activities.“Both nations have come to the table with an ambitious set of asks and a willingness to work together towards a mutually beneficial deal,” said a Department for Business and Trade spokesperson. “We continue to negotiate and we will only agree to a deal that is fair, reciprocal, and ultimately in the best interests of the British people and the economy.” The proposed trade pact has stirred political sensitivities in both countries about migration. Comments by home secretary Suella Braverman last year about immigration by Indians to the UK angered Narendra Modi’s government and temporarily slowed progress on the talks, which began in January 2022. 

“I think there was some misunderstanding amongst your political leadership,” Goyal said. “No trade deal talks about immigration.”He said that India was seeking easier access to the UK for workers in “certain services which can only be done locally”, such as nurses, caregivers and consultants. “We are working together to find solutions.”Goyal added that India was already offering visas to British businesspeople “to come and run their companies”, giving them access to an Indian economy that is expanding at 6-7 per cent a year. The official said that given the expected divergence between the economies’ sizes in coming years, India was pushing Britain to bring more “equity and fairness into the deal”, including in the form of transition periods or “disproportionate opening up” for India in some sectors. “Without that, the deal won’t happen,” Goyal said. More

It must have caused some rolling of eyes in European board rooms when Germany’s chancellor Olaf Scholz last week told companies it was up to them to manage de-risking from China. Multinationals have been deafened for years by a cacophony of conflicting exhortations from EU governments, the European Commission, Joe Biden’s White House and Xi Jinping’s administration — increasingly backed by open-ended subsidies — advising them where to invest.Scholz’s words, which were strikingly similar to what Li Qiang, China’s premier, told German corporate executives a week earlier, were surely disingenuous. Even in less fraught times, highly politicised trade disputes mean that business and official decisions in certain sectors are intertwined — particularly in Germany, given its powerful government-corporate-trade union nexus.And these days, national and economic security imperatives are rising. Some parts of German industry in particular are already locked too far in to a model of engagement with China not to expend political capital arguing for trade and investment to be kept open. Reluctantly, we should probably wish them at least some luck. But along with that needs to come a more far-sighted view about building a diverse and competitive economy.Companies operating in sensitive areas like high-end semiconductors may not like disengaging from China — the American chip company Nvidia warned recently about the cost of decoupling — but those exposed to the coercive powers of the US administration, even those in Europe, don’t have much choice. Last week, the Dutch government announced the new export control regime for semiconductor equipment that Washington has bullied it into creating. By creating a case-by-case licensing requirement, it essentially forces every export deal by the Dutch chip machine manufacturer ASML with a Chinese entity to run the gauntlet of the US government, which may deem the sale a national security threat.There is more corporate room for manoeuvre in less sensitive technologies such as, say, electric vehicles. But here too it’s going to be impossible to take business decisions without heavy input from the political process.Indeed, there’s currently an escalating debate within the EU over what role to allow China in Europe’s expanding electric vehicle market. Thierry Breton, the French internal markets commissioner, recently threatened an antidumping investigation into Chinese EV manufacturers exporting to Europe, which could in theory also hit European companies selling into the EU from their Chinese plants. And if the commission is really hell-bent on decoupling, it could use its new regulation against state-subsidised companies to deter Chinese car businesses from building plants in the EU. But German (and especially Volkswagen) investment in China’s car sector, both for sales in China and exports elsewhere, mean the traditional German instinct for avoiding trade disputes and remaining open to China persists — even though Scholz’s coalition government is tacking away from his predecessor Angela Merkel’s alignment with Beijing.Grudgingly, we should concede that German industry probably has a point here. China has established such a strong global lead in EV technology and production capability that trying to exclude it from the EU market is counterproductive. As my colleague Martin Sandbu has written, if the EU wants to build its own green tech industry, then encouraging domestic take-up (as did China with EV purchase as well as production incentives) is a better route than trying to disengage from China. In any case, the “distance effect” in trade for EVs seems to be rising: the cars are likely to be built close to where they’re bought, a good sign for the prospects of expanding production inside the EU.I say grudgingly because here we’re in a world of corporatist mercantilism rather than a competitive market, and the European business-government nexus has shown a woeful lack of foresight in shifting towards EVs. German car manufacturers and their friends in government have spent far too long trying to extend the use of conventional engines, including failing to clamp down on the faking of emissions tests in the Dieselgate scandal, rather than embracing change and encouraging the take-up of EVs.For all Scholz’s talk of a clear division between government and business, the idea of a company like VW making decisions divorced from official influence is absurd. VW is a part publicly-owned enterprise (the state of Lower Saxony holds a stake and has important veto rights) with a powerful trade union presence and longstanding influence on German trade and investment policy. There’s a strong argument for weakening those links, but for the moment it’s pointless to pretend they don’t exist.Some sectors will always come under more government influence than others, but companies operating in an increasingly politicised environment need sharper awareness of the potential for official interference. Taking EVs as an example, the extent of interference remains uncertain, while companies’ own reactions to technological and market developments have been dilatory and reactive. De-risking trade with China has to proceed from a realistic appraisal of what governments can and should be doing, not promulgating the illusion that they have no role to play at [email protected] More

© Alberto AntoniazziA common view in the financial industry is that carbon prices are detrimental: by reducing the profitability of companies, a higher price will lower share prices. But, while this may be true in the long run if carbon taxes permanently rise at a constant rate, it can be argued that, in the short to medium term, a price on carbon emissions can reduce macroeconomic risk — and hence benefit financial markets. One key condition is that carbon pricing needs to respond to economic fluctuations.Financial markets have entered a new era that incorporates sustainability. They have become central to the global effort to address climate change and build a more sustainable future. As the world shifts to a low-carbon economy, carbon pricing policy is increasingly important in investment decisions. It is creating new opportunities for sustainable investments and driving the growth of green finance.Climate policy also raises important macroeconomic challenges. Reaching net zero by 2050 requires a permanent increase in the price of carbon. To comply with stringent emission reduction targets, companies will either have to pay a carbon price or reduce their emissions by investing in greener production facilities.As underlined in our latest research, Green Asset Pricing, carbon price policies will play a central role in shaping market fundamentals. Indeed, the world cumulative sum of investment spending to reach net zero represents half of current GDP, while carbon tax revenues could represent 5 per cent, according to Jean Pisani-Ferry of the Peterson Institute for International Economics. Carbon policies will therefore not only affect the earnings and growth prospects of companies but also governments’ ability to finance deficits. Our main contention is that, if well-designed, carbon policies can play the role of automatic stabilisers by cooling down the economy during booms and stimulating it during recessions. Indeed, a government that reduces the price of carbon during a recession provides relief to companies by supporting their profitability. Lowering the price of carbon in downturns not only stimulates production but also supports investment as well as employment precisely when it is most needed. Over the cycle, this policy reduces macroeconomic volatility, as it weakens economic activity and profits during booms.How would a time-varying carbon price affect financial markets? Risk premiums, which in turn affect stock prices, are related to the uncertainty surrounding the economy. Macroeconomic volatility, being a main source of uncertainty for investors, it is a key determinant of risk premiums. A more volatile economy depresses valuations of risky assets by inducing investors to demand higher risk premiums to compensate for this uncertainty. Consequently, well-designed carbon policies can stabilise financial markets and lower risk premiums if they are used to reduce macroeconomic volatility.Reducing the burden of carbon pricing in a recession also makes sense from an environmental perspective. Since carbon emissions are very strongly correlated with the business cycle, they typically decline abruptly during major economic downturns, such as the global financial and Covid-19 crises. The need to curb emissions to preserve the environment is therefore less pressing during periods of major recessions.

Increasing the price of carbon during booms creates strong incentives for companies to adopt greener technologies. Such a policy also lowers procyclicality — variations broadly linked with the wider economic cycle — by reducing investments in “brown” projects that worsen the climate crisis. Given the costs associated with the green transition, however, our results suggest that this transformation should mainly happen during booms, when the economy is strong.These gains are also not limited to financial markets. A reduction in the price of carbon during recessions results in lower energy costs for consumers, which can support spending and provide a further boost to the economy. Such a policy would also help ease political opposition and social unrest linked to higher energy prices, such as those witnessed during the French “yellow vest” protests.But how to implement this policy in practice? Schemes that are connected to economic activity, such as the cap and trade systems implemented in Europe and California, could in principle reconcile economic, financial and environmental objectives. While still imperfect, the EU’s Emissions Trading System in recent years delivered the positive correlation between the price of carbon and economic activity that is needed to achieve these gains.In summary, if connected to economic activity, a price on carbon emissions can have beneficial effects on financial markets by reducing economic procyclicality. A reduction in macroeconomic volatility not only lowers the premiums demanded by investors for holding risky assets but also stabilises financial markets. Moreover, the examples of Europe and California suggest that time-varying carbon policies can be successfully implemented in practice. Ghassane Benmir of the London School of Economics and Political Science, Ivan Jaccard of the European Central Bank, and Gauthier Vermandel of CMAP, Ecole Polytechnique, Paris, and PSL Research — Université Paris Dauphine, are authors of Green Asset Pricing (ECB working paper, 2020). The views expressed in the paper and this article are those of the authors and do not necessarily reflect those of the ECB. More