Lucrezia Reichlin | Inflation targeting in the age of climate change

At the end of April, in a speech at the Sorbonne, French President Emmanuel Macron suggested that European leaders should consider broadening the European Central Bank’s mandate to include decarbonisation targets.

His proposal has mostly been ignored; for many, it probably seems too radical to be worth discussing. But it is not really very radical at all, and disregarding it would amount to a major missed opportunity.

The ECB’s price stability mandate, like its independence, has been always considered “untouchable”. But the pursuit of price stability does not happen in a vacuum. The Maastricht Treaty, which established the legal framework for Europe’s monetary union, recognises this. While the treaty states that the ECB’s primary objective must be to maintain price stability, it also dictates that, “without prejudice to” that objective, the ECB should support the European Union’s broader economic policies, with a “view to contributing to the achievement” of the bloc’s objectives.

This has always been interpreted as a hierarchical mandate: price stability comes first, but other objectives – such as employment and financial stability – should also be pursued. So, when the ECB suggested, in its 2021 strategy review, that it would incorporate “climate change considerations” into its policy framework, it was operating on the assumption that climate would be secondary to price stability.

But what happens when the ECB’s objectives clash? The pursuit of price stability can, after all, involve trade-offs. Yet there is currently no established ECB procedure for setting monetary policy when the quest for price stability conflicts with other EU priorities. Macron’s provocative proposal should force European leaders to reckon with this gap – beginning at the next ECB strategy review, planned for next year.

The ECB is not alone. Pure inflation-targeting central banks – such as the Bank of England or Nordic country central banks – and the US Federal Reserve, which has a dual mandate, confront the same types of trade-offs. These central banks pursue their inflation targets on a medium-term horizon, but allow some divergence in the short term, precisely in order to avoid or reduce transitional costs, such as lost employment or output. As former BOE Governor Mervyn King once said, “an inflation targeter is not an inflation nutter”.

But, as with the ECB, these central banks might need a more nuanced and flexible approach. Specifically, when getting inflation back to target quickly is likely to have large costs – in terms of employment, financial stability, and efforts to combat climate change – it might be wise to prolong the central bank’s time horizon. To this end, formal criteria for linking costs to time horizons would have to be formulated.

Accounting for the climate transition will not be easy. Consider the impact of regulatory constraints on the use of fossil fuel technology – a key component of net-zero strategies. These work just like supply constraints arising from supply chain disruptions or geopolitical shocks, shifting the supply curve to the left and making it steeper.

Under these circumstances, changes in demand could lead to price volatility, and inflation-targeting monetary policy might adversely affect employment. In any case, when inflation is caused by supply-side factors, monetary policy’s impact is limited, so other instruments must be used to ease the constraint.

Though mainstream macroeconomic models assume that monetary policy does not affect potential output, there is empirical evidence suggesting that steep interest rate increases might reduce investment in sectors that are perceived to be riskier, even if they might prove more productive in the long run. Perhaps most important in our example is investment in research and development in green technology, which requires massive upfront investment. Monetary policymakers must therefore ensure that efforts to achieve the inflation target do not impede such investment.

While investment in green tech can be encouraged using financial and fiscal instruments, it remains sensitive to financial conditions. So, if central banks tighten those conditions, in order to control inflation in the short run, they risk undermining productivity and sustainability, and even fuelling inflation, in the longer run.

After all, an economy that is less productive and more exposed to both supply constraints and climate risks will be more vulnerable to inflation. Of course, there are also costs to delaying anti-inflationary interventions. The right balance must be struck.

Far from being an esoteric topic for academic economists to discuss among themselves, this is a serious practical challenge that central banks will have no choice but to face in the coming decades. Because the green transition involves the rebalancing of production away from ‘dirty’ processes, it is likely to be characterised by temporary inflationary pressures. Central banks must ensure that their response does not amplify the disruption and increase output costs.

Recognising this, some central banks have already incorporated flexibility into how they approach their mandates. But now they must operationalise that flexibility by devising a transparent and research-based framework for managing the costs and benefits of inflation and other objectives. Macron’s suggestion should kick-start this process.

Lucrezia Reichlin, a former director of research at the European Central Bank, is Professor of Economics at the London Business School.© Project Syndicate 2024www.project-syndicate.org