By Lucrezia Reichlin
During the years of low inflation and zero or negative interest rates, many central banks joined the fight against climate change and started experimenting with various tools such as special loans, asset purchases, and collateral requirements biased toward “green” investments. But with the return of inflation, monetary policymakers have grown more cautious.
Presumably, they are eager to demonstrate that price stability is their primary focus, implying that when inflation is persistently above target, climate policy matters less. But a firm commitment to price stability does not require central banks to drop green-oriented monetary policies altogether. Since today’s central banks have more than one instrument at their disposal, hiking interest rates to fight inflation can, in principle, go hand in hand with targeted green policies. The question is how to do it now that central banks’ balance sheets are supposed to be shrinking.
Moreover, the return of inflation does not alter the original case for green monetary policymaking. Central banks still have two good reasons to remain committed. First, they need to account for climate change in order to manage their own portfolio risk. With regulators and supervisors asking the financial sector to do this, it is only natural that central banks should do it, too.
Public authorities have drawn up new guidelines for the private sector because they recognize that climate risks are financially significant, and that limiting exposure to fossil-fuel assets is fully consistent with traditional risk-management criteria. This is especially true for larger portfolios, and notwithstanding the recent decline in central banks’ holdings, their assets worldwide still total around $40 trillion.
The second reason is that in most countries central banks are mandated to support the general objectives of their governments in guaranteeing citizens’ welfare, as long as doing so doesn’t interfere with price stability. Supporting the green transition therefore should figure prominently within any framework that rigorously assesses the potential trade-offs between price stability and economic policymaking.
Central to this process is the concept of “double materiality,” which holds that you should do what you can to have an impact, and not focus solely on mitigating your own financial risks. Although central banks are not in charge of industrial policy, they do have tools to allocate capital within their normal operations, and these are already in use in many countries.
When the Network for Greening the Financial System (NGFS) reviewed current policies for eight case studies in Asia and Europe, it found that most green measures were motivated by the aim of mitigating climate change, rather than risk management.
For example, in 2021, the Hungarian central bank loaned Ft300 billion ($825 million) to credit institutions at 0% interest on the condition that this funding be lent to households for the construction or purchase of new, energy-efficient residential real estate.
Similarly, in 2021, the Bank of Japan introduced a program that provides 0% interest loans to financial institutions to fund investments or loans that contribute to Japan’s climate goals. The People’s Bank of China has also launched two targeted lending facilities to motivate financial institutions to back emissions-reduction projects; and other major central banks, including the Bank of England and the European Central Bank, have rolled out special corporate-bond purchase programs that favor stronger climate performers.
The NGFS’s findings point to an accumulation of valuable experience in green policymaking by central banks. Though there are relevant differences across these institutions, they collectively represent a huge amount of fire power.
But won’t central banks have to shrink their balance sheets, and won’t that harm their green-related financing? Not necessarily, because with interest rates on reserves, a central bank can, in principle, increase rates to tame inflation while still maintaining a large balance sheet.
The US Federal Reserve has already opted to maintain a system of ample reserves, and since its liabilities will remain large even when inflation is on target, these will have to be matched by large assets.
Under this framework, central banks that have adopted a double-materiality approach can aim for an asset portfolio that is consistent with their government’s climate and industrial policies. In making the choice between larger or smaller balance sheets, they should consider the longer-run advantages of supporting green financing.
To be sure, some will object to any policy that encourages central banks to leave a large footprint in markets, or that tasks unelected officials with what looks dangerously close to an industrial policy. We have all heard the argument: “Central banks are doing too much and risking their independence.”
But climate change is the existential problem for all of humanity. At a moment when the private sector is withdrawing resources from climate funds and public finances are constrained everywhere, the idea that central banks can play a larger role should not be discarded. The devil, of course, will be in the details. Transparency and careful management of trade-offs will be crucial.
• Lucrezia Reichlin, a former director of research at the European Central Bank, is Professor of Economics at the London Business School
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