Finance Ministers rarely mention central banks in their Budget speeches unless there is an important institutional development, or there is a crisis which requires a coordinated response. In the United Kingdom’s Budget Speech 2021, Chancellor Rishi Sunak mentioned the Bank of England for both the causes.
Sunak mentioned that the Bank of England, apart from keeping its 2 percent inflation target, “will also reflect the importance of environmental sustainability and the transition to net zero.” These innocuous sounding words have the potential to change the world of central banking like never before.
A similar change to the world of central banking happened 24 years ago when then Chancellor Gordon Brown announced the Bank of England moving to the inflation target framework (ITF). Though New Zealand pioneered the ITF in 1990, the BoE stamp was required for the ITF to become the new thing in monetary town.
Coming back to the 2021 UK budget announcement, this implies that the BoE will be a partner to the UK government’s goal of zero carbon economy. It is similar to the earlier government goal to lower inflation which led to inflation target, and now to the lower carbon economy. It is a reminder to central bank watchers that ultimately the government sets goals and the central banks simply work around policy to implement these goals.
Unlike the ITF, the Bank of England has also played a pioneering role in climate change. Former BoE Governor Mark Carney first highlighted the dangers in his 2015 speech, provocatively titled ‘Breaking the tragedy of the horizon’. Carney highlighted how we all have to fight climate change and the central banks need to be involved as well. Carney’s speech prompted several central bankers to speak about climate change and undertake studies on the topic.
Despite the similarities between inflation and climate change, the differences couldn’t be starker. The journey to the ITF was a natural one for the central banks. The central banks after all are guardians of monetary and financial stability. From the 1970s, most countries struggled with high inflation leading to the central banks experimenting with policies such as targeting inflation via money supply. As these policies did not show desired results, the ITF emerged where the central banks targeted inflation via interest rates.
Unlike inflation, climate change is not a natural ally for a central bank, and this obviously becomes a major challenge. Carney and others have identified how ignoring climate change leads to concerns for both price and financial stability. The floods and droughts could lead to destruction of crops leading to higher inflation. Likewise, these climate change events could lead to large losses for banks (insurance) firms which have lent (claims) to these areas creating financial instability. Of late, we have seen how the US Federal Reserve along with other financial regulators passed policies providing relief to financial institutions affected by Texas Winter Storms.
As prevention is better than cure, the central banks have decided to play a role in this climate change. They are primarily trying to promote greening of finance, which means encouraging financial institutions to increasingly support firms which have lower carbon footprint. The central banks are also promoting green bonds and also considering accepting these bonds as collaterals for repo and inter-bank borrowing transactions. This indirect policy will hopefully have a direct impact on climate change.
The linking of climate with the central banks has raised concerns among purists. They point that each time the central banks move away from their core objectives of monetary stability, there is trouble ahead. They point to examples from the 1970s where inflation rose as the central banks were focusing on growth and employment. Some purists were not happy with the central banks taking up the role of financial stability post-2008 crisis. The New Zealand Central Bank has already added employment to its objectives and has recently been asked to include housing market sustainability to their remit as well. They argue that the central banks have earned their autonomy after years of inflation management, and should stick to the knitting, else risk losing their autonomy.
How do the central banks work around these conflicts? If they do not join the fight for climate change, their role as a public policy institution will be questioned. If they join, they will be criticised for moving away from core goals.
Apart from the Bank of England, the central banks in Europe have also played a leading role in discussions on climate change. Last year, Denmark’s central bank announced the recruitment of a climate economist to work with its macroeconomics team. The European Central Bank (ECB) is also likely to adopt climate change as a formal goal after completion of its ongoing review. The central bank has already set up a climate change centre.
Isabel Schnabel, a key ECB official, in a recent speech remarked that while the primary responsibilities of climate change lie with the governments, “there is by now a widely shared understanding that central banks cannot stand on the sidelines”. So the question is not if the central banks can incorporate climate into their goals ‘but how and to what degree this should be done’.
What does all this mean for the Reserve Bank of India, which will announce a review of its monetary policy in March 21? The recent RBI Report on Currency and Finance (RCF), which studied the evolution of monetary policy frameworks in India and the world, has some answers. The RCF recommended that the RBI should continue with the current ITF of 4 percent with a band of 2 percent. However, the world is undergoing several ‘structural changes such as globalization, e-commerce and climate change’. These changes may test the ITF.
Thus, lessons from the ongoing reviews of other central banks will ‘be invaluable’ to understand whether the core goals need to be complimented with these alternative goals. The BoE has already gone ahead incorporating the climate change goal to the ITF. We have to wait and see what other central banks, including the RBI, will do in their ongoing/upcoming reviews.