Good morning from New Economy Brief.
Most economists understand that climate change is going to reduce incomes, destabilise financial systems and damage economic growth rates across the world by destroying productive capacity (capital, real estate, investor confidence), displacing workers and pushing up prices of food and other essentials.
Forward-thinking central banks are grappling with this idea, but how can monetary policymakers ensure that their own actions to change interest rates don’t make it harder to mitigate and adapt to climate change?
This week’s New Economy Brief explores a recent paper from the Network for Greening the Financial System (NGFS) on how monetary policymakers should respond to ‘climateflation’.
–
How will extreme weather affect the economy?
The paper is from the NGFS monetary policy workstream, chaired by the Bank of England’s James Talbot. It surveys the evidence on how “severe weather shocks” affect growth and inflation. The global cost of damage from events like droughts, floods and storms has more than doubled since the early 2000s, reaching $275 billion in 2022, and the paper warns that this is likely to get much worse as we approach 1.5°C of warming.
Impacts on growth. These events don’t just destroy infrastructure and disrupt supply chains; they also cause indirect economic losses, such as reduced investment, lower consumption, and disrupted trade. This can have a significant impact on GDP growth rates, although the authors say it's unclear whether this is transitory or persistent – a one-off cost or a long-term drag on the economy. Severe weather events have huge effects on global commodity prices, especially in agriculture and energy where production is concentrated in vulnerable regions. For instance, the paper’s authors found that a 10% increase in global food prices due to bad weather will lower the average country’s GDP by 0.5% after a year and a half. And 10% is a relatively modest increase by recent standards, so there’s the potential for much more painful economic effects. Advanced economies are particularly vulnerable because they often produce little of their own food and rely on imports.
Supply and demand impacts on inflation. The destruction of productive capacity leads to supply-side inflationary shocks, which can prompt monetary policymakers to increase interest rates. However, severe weather can also reduce demand in the affected economy. This is due to economic losses from unusable infrastructure, less spending due to declines in wealth (e.g. house prices on flood plains) and incomes, disrupted trade flows, investor uncertainty about future climate events, and more. The authors note that “when insurance mechanisms fail to carry a significant share of the costs, the burden placed on government finances limits the space for other productivity-enhancing public investments.“ They suggest that before changing interest rates, monetary policymakers need to clearly identify the supply and demand components that are pushing inflation in opposite directions.
–
Investment in adaptation is key.
The NGFS authors explain that how much economic damage a disaster inflicts depends on the vulnerability of the affected area, which in turn rests on “factors like construction quality, building codes, and disaster preparedness”, pointing out that these are often tied to a country's wealth and development. They note that investing in climate adaptation and resilience can reduce the economic damage from increasingly severe weather events, but warn that current spending “focuses more on disaster recovery than on risk reduction, with new risks emerging from development in high-risk areas. Adaptation measures can lower potential damages, reducing the burden on insurance markets and improving risk protection.”
The UK’s poor progress in adapting to climate risks. The Environment Agency warned the previous government to “Adapt or Die” , pointing to the impacts of increased rainfall and flooding in the UK under a 2°C warming scenario. The report details sea level rises, changes to winter and summer rainfall and peak river flows, and the need for extra public water supplies. The Climate Change Committee’s Third Independent Assessment of UK Climate Risk argued that “Adaptation action has failed to keep pace with the worsening reality of climate risk. The UK has the capacity and the resources to respond effectively to these risks, but it has not yet done so. Acting now will be cheaper than waiting to deal with the consequences.”
–
How could monetary policymakers respond?
The NGFS paper emphasises that grappling with persistent inflationary pressures from extreme weather poses a challenge for central banks, which “have to wrestle with the question of long-term implications of physical hazards for potential and output and growth and the appropriate longer-run stance of monetary policy”. This is part of a much bigger debate on how monetary policy should adapt to a new environment of accelerating climate shocks and permanent instability. There is a particularly clear need to make sure central banks’ actions don’t actively impede efforts to mitigate and adapt to climate change. (Read our previous New Economy Brief on inflation and instability for more on this.)
Central banks shouldn’t impede investment in decarbonisation and adaptation. Preventing the worst economic damage from extreme weather requires investment (both public and private) to decarbonise quickly and build resilient infrastructure, supply chains and more. If monetary policymakers across the world respond to accelerating severe weather shocks by raising interest rates, they will slow down investment by increasing borrowing costs. Green projects are particularly vulnerable to higher interest rates because they need so much upfront capital investment. Higher interest rates in the developed world have also deepened the sovereign debt crisis in the developing world, as borrowing costs for governments in lower-income countries have soared. This has reduced their ability to invest in adaptation, which will come back to hurt advanced economies as extreme weather shocks push commodity prices up and lead to imported inflation.
Shield green investment from interest rate hikes. One solution to this is for central banks to let low-carbon projects borrow more cheaply. Since 2022 the Bank of Japan has been providing zero-interest financing to banks that in turn lend to projects that address climate change, arguing this falls within its price and financial stability mandates. The New Economics Foundation proposed that the UK could do this by repurposing the BoE’s Term Funding Scheme – which currently reduces borrowing costs for businesses and households – to instead encourage banks to provide cheap funding for sustainable projects. (Read our previous New Economy Brief for more on Green Credit Guidance)
Moving beyond 2% inflation targets. Olivier Blanchard, former chief economist at the IMF, thinks it is time to revisit the 2% inflation target, arguing that ”the right target for advanced economies…might be closer to 3 per cent”. Raising the target would reduce the pressure on monetary policymakers to put the brakes on investment whenever inevitable climate-induced supply shocks hit. It could reduce borrowing costs and encourage investment in making economies more resilient. Some economists have suggested enhancing the Bank of England’s financial stability mandate to make it coordinate more explicitly with the Treasury. They argue that it shouldn’t be targeting inflation at all, but growth, concluding that “the proper regulation of employment and investment in the economy is a matter of policy for Government, not the central bank.” (Read our previous New Economy Brief for more on the case for monetary and fiscal coordination).
The OBR’s view on public investment. The Office for Budget Responsibility (OBR) has released an important report explaining how it calculates the long-term impact of public investment on economic growth and the public finances. The authors find that increasing public investment by 1% of GDP boosts output by 0.5% after 5 years, but 2.5% after 50 years. They also explain why public investment is good value for money, as the fiscal return on public investment is higher than government borrowing costs.
A real 4-day week. While the government’s plans for flexible working are a welcome step in the right direction, reducing overall working hours is crucial, argues the 4-Day Week Campaign’s Saskia Wootton-Cane. The government is planning to make it easier for workers to compress their hours into a four-day week, rather than to move towards fewer hours with no loss of pay.
Taxing the banks. Positive Money has calculated that a 35 per cent tax on the £44.3 billion pre-tax profits reported by HSBC, Barclays, Lloyds and NatWest in 2023 would raise £14 billion. Positive Money’s Simon Youel argues that the government should look at other countries such as Spain which have successfully raised revenue through taxes on banks.
The myth of capital flight. A study by the London School of Economics finds that the rich are very unlikely to relocate because of tax rises alone, particularly those living in large cities like New York, London and Tokyo. The study, which involved interviews with 35 high-net-worth individuals, found that tax havens are “ultimately too boring” for the rich to seriously consider moving there if taxes in their home countries were to increase.
Private vs. public financing. Former Civil Service head Gus O’Donnell has warned the government not to “play accounting games” and use PFI to cut Government spending. O’Donnell also said that “it is important that we invest a lot more… if you are going to improve productivity, it will involve investment in capital and people that’s going to take some money.”
Designing the National Wealth Fund. Positive Money suggests that the government’s new National Wealth Fund (NWF) could be empowered to use its recent £7.3 billion funding boost to mobilise £180 billion for public investment by the end of this Parliament. The research argues that excluding the NWF’s borrowing from the government’s fiscal rules as well as having strong trade union and civil society presence on governance boards would be key to the programme’s success.
Rent controls in Scotland. 82% of Scots support the introduction of rent controls, which are included in the Housing (Scotland) Bill, according to new YouGov polling commissioned by Future Economy Scotland. The polling also found that a majority in every Scottish region support capping what private landlords can charge, and that the measure is popular with SNP voters (90%), Labour voters (88%) and Conservative voters (61%) alike.
