Impact of Climate Mitigation Policies on Monetary Policy Effectiveness

Francesca Diluiso, Boromeus Wanengkirtyo, and Jenny Chan

This analysis explores critical aspects of climate mitigation policies that may affect monetary policy, drawing on insights from structural climate macroeconomic models, particularly the Environmental Dynamic Stochastic General Equilibrium (E-DSGE) framework. Key findings include how mitigation measures, specifically carbon pricing, can trigger shocks with significant implications for monetary policy. Additionally, the anticipated nature of these policies shapes their macroeconomic repercussions, while varying climate policies may influence the transmission of conventional business-cycle shocks.

Climate Change Mitigation as a Source of Economic Shocks

To meet climate objectives, orderly transition scenarios anticipate a consistent rise in carbon prices, as per the Network for Greening the Financial System (NGFS, 2023). Such price trajectories will have profound macroeconomic implications. Historical data from markets like the UK and the EU Emissions Trading System (ETS) indicate substantial fluctuations in carbon prices, impacting inflation and GDP.

Recent analyses, including those by Mann (2023) for the UK and Känzig (2023) for the eurozone, suggest that rising carbon prices tend to increase inflation rates. In our E-DSGE model, a rise in carbon price represents a cost-push shock, which correlates with inflation spikes and GDP declines. Notably, under a Taylor rule framework, where monetary policy adjusts in response to inflation and output fluctuations, sudden carbon price hikes exert upward pressure on inflation and negatively affect economic output. The potential for a continual series of shocks—referred to as a "carbon price ratchet"—could create significant challenges for policymakers as they navigate trajectories toward a sustainable carbon price level.

The Role of Expectations in Climate Policy

The economic implications of carbon pricing significantly depend on how these price adjustments are anticipated by agents in the economy. When a carbon price increase is perceived as short-lived (represented by the dashed line in Chart 1), consumption and investment declines are fleeting, with a faster subsequent recovery of output as inflationary pressures alleviate. Conversely, a permanent or gradually rising carbon price (as illustrated by the solid line) results in a more substantial and lasting drop in aggregate demand as businesses and consumers adjust their expectations regarding the longevity of these policies. This anticipation leads to more profound changes in investment and consumption patterns.

As households and firms adjust their expectations about future policy stringency, their current economic decisions—such as spending and investment—reflect these anticipated changes. Therefore, permanent policy shifts can lead to a more pronounced decrease in output and weaker inflation responses, underscoring the importance of how forward-looking agents process climate policy changes. Notably, empirical studies suggest that climate transitions may create mild inflationary effects or even deflationary trends based on these adjustment mechanisms.

Interplay between Carbon Pricing Policies and Conventional Macroeconomic Shocks

Beyond direct inflation and output effects, various carbon pricing mechanisms can modify how conventional macroeconomic shocks are transmitted. Different policies—like cap-and-trade versus carbon taxes—result in distinct behavioral responses in emissions and economic activity. A carbon tax, by fixing emission prices, allows market dynamics to determine the level of emissions reductions, while a cap-and-trade system fixes the total emissions allowed, leading to variability in emission prices.

In response to positive supply shocks, a carbon tax would similarly reduce marginal costs associated with capital and labor, leading to inflation and output shifts that mimic traditional economic responses. Yet, under a cap-and-trade scheme, an automatic stabilizing effect occurs; increases in production raise demand for emissions permits, thereby raising operational costs and dampening the inflation and output improvements typically expected from a supply shock.

Chart 2 illustrates the distinct responses to supply and demand shocks under both pricing regimes. For example, following a contractionary monetary policy shock, a cap-and-trade system results in a pronounced drop in inflation while keeping output volatility lower, suggesting a unique stabilizing capacity within this framework.

Conclusion: Implications for Monetary Policy

While monetary policy cannot directly address climate change, understanding the economic ramifications of climate policies is vital. Factors such as extreme weather impacts and the transition to greener sectors necessitate close monitoring for their potential effects on expected inflation and output. As Catherine Mann aptly stated, central banks should adopt a forward-looking stance to effectively gauge how climate considerations may influence their monetary policy objectives. The exploration of carbon pricing's impacts on inflation trade-offs, the importance of expectation management, and the diverse transportation effects of carbon policies further enrich the understanding of climate's economic implications on monetary approaches.

Francesca Diluiso and Boromeus Wanengkirtyo contribute from the Bank’s Structural Economics Division, while Jenny Chan represents the Bank’s External MPC Unit.

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