Benoît Cœuré, Member of the Executive Board of the ECB spoke of the connection between monetary policy and climate changes at the conference on “Scaling up Green Finance: The Role of Central Banks”, organised by the Network for Greening the Financial System, the Deutsche Bundesbank and the Council on Economic Policies on the 8 November 2018.

He started observing that, without further mitigation, cumulative emissions pose significant risks of economic disruption. There is a wide recognition that environmental externalities should be primarily corrected by first-best policies, such as taxes, hence all authorities, including the ECB, need to consider the appropriate response to climate change.

The Financial Stability Board’s Task Force on Climate-related Financial Disclosures published its first status report just a few weeks ago. Only last week, ECB Banking Supervision communicated to banks that climate-related risks have been identified as being among the key risk drivers affecting the euro area banking system.

Yet an area that has received less attention though, both in policy and in academia, is the impact of climate change on the conduct of monetary policy. He argues that climate change can further complicate the correct identification of shocks relevant for the medium-term inflation outlook, it may increase the likelihood of extreme events and hence erode central banks’ conventional policy space more often, and it may raise the number of occasions on which central banks face a trade-off forcing them to prioritise stable prices over output.

To appreciate how climate change may affect monetary policy, it is useful to first recall the basic principles of how central banks decide on their actions. Broadly speaking, implementing monetary policy is the practice of identifying the nature, persistence and magnitude of the shocks hitting the economy. Policymakers typically differentiate between two broad categories of shocks.

The first is demand shocks. These are shocks that are “benign” or manageable from the perspective of monetary policy because they pull inflation, growth and employment in the same direction – a “divine coincidence” which does not pose a dilemma to central banks. The second category relates to supply-side shocks. These shocks are less easy to accommodate for central banks as they pull output and inflation in opposite directions. This generates a trade-off for central banks between stabilising inflation and stabilising output fluctuations. Climate-related shocks typically fall into this second category of shocks.

Droughts and heatwaves often lead to crop shortfalls, putting upward pressure on food prices.Hurricanes and floods destroy production capacity, thereby raising input and output prices. And unusually cold winters can be seen as malign productivity shocks – that is, they may raise input prices for the same level of output.

So, much like other supply shocks, weather-related disturbances typically pose a dilemma for central banks, which may then have to choose between stabilising inflation or economic activity. Policymakers have usually resolved this trade-off by calibrating their response to a supply-side shock according to its estimated persistence and size.

If the shock is thought to be short-lived, and unlikely to affect the medium-term inflation outlook relevant for monetary policy, we usually “look through” the shock – that is, we tolerate its temporary effects on inflation without taking any action. If the effects prove more persistent, however, and are at risk of spreading more widely through the economy, monetary policy action may be warranted.

It is fair to say that most weather-related shocks have been short-lived and contained – at least so far. This year’s extremely hot and dry summer, for example, meant smaller harvests for many European farmers. But its overall price effects have been limited to vegetable prices, and will probably prove to be temporary. Similarly, although the flooding in June 2013 was the most severe in Germany since the 1950s, its macroeconomic impact was limited. As a result, the ECB, in its short history, has never yet been compelled to take action in response to climate-related shocks. So far their largely temporary effects on output and inflation have allowed us to look through them. This meant that central bankers thought the horizon of climate change was extending well beyond the one of monetary policy.

But this may change – he argues – the horizon at which climate change impacts the economy has shortened, warranting a discussion on how it affects the conduct of monetary policy. That is, climate change is likely to affect monetary policy one way or the other – whether it is left unchecked or humankind rises to the climate change challenge.

In recent years, for example, we have repeatedly observed an unusual blip in economic activity in the United States in the first quarter. This has often been attributed to a harsh winter, despite best efforts to seasonally adjust the data. But causality is inherently difficult to establish. Indeed, statistical analysis has challenged the hypothesis that cold temperatures are behind the observed deceleration in first-quarter growth.

Similarly, last month, we saw a puzzling persistence in petroleum prices in Germany despite a parallel fall in oil prices. One hypothesis is that this year’s hot summer caused the water levels in German rivers to fall to levels that only allow petrol tankers to carry half their capacity, creating supply bottlenecks.

It will thus become increasingly difficult for central banks to disentangle the variation in the data relevant for the assessment of the medium-term inflation outlook. It will cause the signal-to-noise ratio to deteriorate and thereby increase the risk that central banks take action when in fact they shouldn’t, or vice versa.

Furthermore, the longer the risks of climate change are ignored, the higher the risks of catastrophic events, possibly with irreversible consequences for the economy. In other words, the distribution of shocks may become more “fat-tailed”.

The concern is that monetary policy may be more often forced to adopt non-standard policy measures. The global financial crisis has shown that extreme events can quickly erode central banks’ conventional policy space. Catastrophic climate change could thus test the limits of how far monetary policy can go and, in the extreme, force us to rethink our current policy framework.

The third and final implication relates to the persistence of shocks and the inflation-output trade-off central banks may face. Climate change, for example, will make some areas of the world less habitable, which can be expected to increase the frequency and intensity of international migration. The events of recent years, though different in nature, highlight how migration can have long-lasting effects on broader labour market dynamics and, ultimately, wage developments. There is evidence that migration has contributed to dampening wage growth in Germany in recent years, thereby further complicating our efforts to bring inflation back to levels closer to 2%.

Similarly, in the absence of clear and tangible evidence that the demand for fossil fuels will decline, and with existing conventional oil fields depleting rapidly, persistent energy shocks cannot be ruled out.

More frequent climate-related shocks may increasingly blur the analysis of the medium-term inflationary pressures relevant for monetary policy. More fat-tailed shocks may erode central banks’ conventional policy space more often in the future. The ECB will thus concentrate its efforts on supporting market participants, legislators and standard-setting bodies in identifying the risks emerging from climate change and providing a clear framework to reorient financial flows and reduce such risks. A unified framework is the gravitational force needed to finance the greening of our economy.

Monetary policy and climate change: complete speech (HTML)