Climate-related risks pose financial stability concerns for the Federal Reserve and European Central Bank.
Traditionally, financial market actors and monetary authorities have considered environmental matters as outside of the scope of monetary policymakers. This stance may change now that central banks are beginning to recognize that climate change could present real threats to price stability.
Central banks are tasked with managing the money supply while also maintaining price stability. Their key instruments are interest-rate targets. Lower interest rates encourage economic growth in two ways: first, by reducing borrowing costs for firms wanting to invest in new projects, and, second, by increasing the purchasing capacity of consumers with credit card debts and mortgage borrowers.
But stimulating economic growth could also spark inflation, as too much money chases a limited number of goods. Inflation hurts long-term economic growth and lower-income groups without indexed incomes. So, to guide monetary policy toward price stability, most central banks aim for an inflation target of 2 percent.
One way to protect a central bank’s effectiveness in controlling inflation is to insulate it from political pressure as political leaders may want to institute an unwarranted “easy” monetary policy with low interest rates, especially before elections. Low interest rates might give economic growth a short-term boost, but it could create inflation in the longer term. Central bank independence from the executive and the legislature allows them to fend off such inflationary pressures.
When it comes to climate change, central bank traditionalists see the problem as fundamentally a political issue, not directly linked with price stability mandates. Moreover, banking’s traditional puritans believe that central banks do not have the tools to translate climate science into actionable metrics for addressing climate risks. They fear that if central banks cave in on climate issues, other political issues will come next.
Yet it is clear that climate change does create new threats to the economy. For central banks, addressing climate considerations may be as simple as applying their normal framework for financial risk assessment. Climate change presents three types of risks for financial markets: physical, transition, and liability.
Physical risks mean that firms may suffer physical damage to their operations from hurricanes, sea-level rise, forest fires, or drought.
Transition risk means that changes in regulations or consumer preferences may alter business models, hurting carbon-intensive businesses and favoring low-carbon ones.
Liability risk means that courts may increasingly hold firms responsible for climate costs and order them to compensate parties hurt by their actions or inaction.
If firms face these three kinds of risks, then so do the banks that have lent to them. This relationship explains why central banks, as lenders and overseers of financial stability, need to get involved in the assessment of climate risks.
Observers who believe in “perfect markets” might expect omniscient financial markets to consider climate risks in asset pricing, without any prodding from central banks. Yet, despite efforts to incorporate climate change into the stress testing of banks, financial markets do not address climate change in a meaningful way. For example, mortgage lenders still do not factor climate vulnerability into their business decisions. Banks with mortgage-backed assets on their balance sheets are, therefore, overvaluing collateral.
Central banks could intervene to ensure that no risk is left behind. They could address climate-induced risks by encouraging appropriate asset pricing for collateral that banks require from borrowers, supporting “green bonds” in asset purchasing programs, or updating their own collateral requirements when lending to commercial banks.
The challenge is deploying the tools needed to assess all the risks.
Central banks have not cohesively responded to the climate issue, with the U.S. Board of Governors of the Federal Reserve System and the European Central Bank (ECB) taking different positions. Jerome Powell, Chair of the Federal Reserve, maintains that climate change is a concern only as it relates to the Federal Reserve’s mandates. In July 2021, when testifying before the House Financial Services Committee, for example, Powell clarified that the Federal Reserve’s “work on climate change really exists as part of our preexisting mandates for supervising financial institutions and for the overall stability of the financial system.”
By contrast, the President of the European Central Bank, Christine Lagarde, has articulated a different approach. Since the beginning of her tenure as president, Lagarde has been vocal about her perspective on climate impacts. She explained in her first official parliamentary hearing that “when we construct models, when we try to measure the output gap, when we try to forecast growth, when we try to have identification of expected inflation, we need to embed climate change imperatives in that work.” Moreover, Lagarde is not shy about her desire to see the ECB include climate change in its primary mandate.
If Powell and Lagarde support a similar aim, anchored in the logic of risk assessment and price stability, why do they frame it differently? Arguably, the Powell-Lagarde divergence reflects the politics of the two jurisdictions. Sharp political polarization in the United States limits the Federal Reserve’s room to become vocal on climate policy. It cannot afford to be seen as taking sides. Powell could be seeking to safeguard the Federal Reserve’s image of political neutrality, the way Chief Justice John Roberts is sometimes portrayed as doing so for the Supreme Court.
Lagarde does not face such constraints, given the widespread support for climate issues in the European Union, even among conservative parties. Perhaps this consensus is why she can make statements declaring that the “true social and environmental costs of carbon need to be included into the prices paid by all sectors of the economy,” which could spark off a political firestorm in the United States.
Countries create independent administrative or judicial branches to ensure that politics does not undermine good governance. The expectation is that, armed with deep expertise and protected from political pressures, politically insulated bodies will make decisions—even unpopular ones—that foster long-term health of the country. Yet, these independent bodies also need legitimacy from citizens. Although they cannot be perceived as responding to political pressure, they cannot ignore it either, especially in an era of rising populism.
The difference between Powell and Lagarde’s responses to climate issues may reflect the varying climate politics in the two jurisdictions. At a substantive level, however, both recognize the risks that climate change poses to the financial system and its eventual interference with central bank mandates to maintain price stability.
Eventually, the proof of the pudding lies in its eating. Instead of fixating on what central banks say, we should focus on what they do. Maintaining price stability will probably remain the most important metric for assessing their behavior. Yet innovations to enhance the resilience of the financial system against climate risks might soon become another metric.