The difficult relationship of monetary policy and green transition
There are different views on the role of central banks in the green transition. This was made clear at the Stockholm symposium in January. According to Fed Chairman Powell, it does not fit the Fed mandate and is a task for elected policymakers. ECB Executive Board member Schnabel, on the other hand, while acknowledging that price stability is a priority for the ECB, wants to compensate for the limited “green ammunition” for the ECB in times of monetary tightening by, among other things, the active rebalancing of existing ECB policy portfolios. The different position also has to do with the precise wording of the respective mandate of the Fed and the ECB. While the Fed mandate is strictly limited to three objectives (price stability, employment and moderate interest rates), the ECB can also support general EU policies as long as price stability is assured. In practice, however, this vague wording causes controversy. After all, in this way the ECB becomes a political policymaker by the back door. Since this dilemma is embedded in the EU treaty, it will always remain a difficult political balancing act for the ECB.
”We are not, and will not be, a climate policymaker.” With those words, Fed Chairman Powell concluded his contribution in January at the symposium on central bank independence in Stockholm. “[...] we stand ready to further intensify our efforts to support the fight against climate change”, ECB board member Schnabel replied at that same symposium. Those statements illustrate the intensity of the debate on the role of monetary policy in the green transition.
‘Free lunch’ for central banks over
The years of a ‘free lunch’ (or ‘divine coincidence’) for central banks seem to be definitively over. After the 2008 financial crisis, low inflation, which remained structurally below the inflation target, allowed for an unseen expansionary monetary policy. This served to support growth, but increasingly also for other purposes such as promoting favorable financing conditions (also for) for governments and, certainly in the case of the ECB, also for broader social considerations including support for the green transition. The most extreme position in this took the advocates of Modern Monetary Theory (see also the KBC Economic Opinions of 21 June 2019 and 11 June 2021).
Not only in the ECB, but also in the Fed, this thinking seemed to take hold, until rebounding inflation dampened the enthusiasm. In the most recent update to its August 2020 monetary policy strategy, the Fed, while taking the 2% inflation target as a given, expanded the operational definition of “maximum employment”. The Fed would also take into account socio-social aspects of it, such as pursuing a more inclusive labor market.
The end of the period of too-low inflation brings back to the fore the trade-offs traditionally faced by central banks. This could potentially compromise the independence of central banks (see also KBC Economic Opinion of 22 January 2019). That dilemma can be summed up by ‘Tinbergen’s rule’, which states that policymakers need at least as many independent policy instruments as they have independent objectives. Therefore, in addition to monetary policy, fiscal policy and regulatory authorities must also play their role to achieve the different objectives of high growth, price stability and green transition together (see also KBC Economic Opinion of February 4, 2022).
Fed Chairman Powell’s position amounts to saying that price stability is the primary policy goal (alongside the other two primary goals of employment and moderate long-term interest rates). Anything else is a matter for the elected representatives. Indeed, an explicit climate policy, Powell argues, can have a significant impact on the distribution of incomes and wealth, in addition to impacting companies, sectors, regions (see also KBC Economic Opinion of 7 January 2021). That is a task for the elected government, and not for the Fed as long as it is not explicitly included in the statutory Fed mandate. In doing so, he does make an explicit exception for the Fed’s role as a regulator. That includes the Fed identifying financial risks of banks as a direct result of climate change.
ECB board member Schnabel agrees with the principle that the first-best solution to address the green transition lies in the hands of fiscal policy. In this sense, the ECB agrees that green dominance on monetary policy should be avoided. Schnabel even argues that ensuring price stability is conducive to the green transition in the medium term, since it would rely mainly on capital-intensive and interest-sensitive projects.
In addition, unlike Powell, Schnabel does see an explicit role for the ECB in the green transition. On the one hand, the end of QE and the start of quantitative tightening means that the ECB can no longer “green” its policy portfolios through targeted net purchases. Therefore, as a compensation, Schnabel proposes a policy of active rebalancing of existing policy portfolios (including those of the CSPP). The criteria for assets eligible as collateral in ECB refinancing operations could also be tightened, as well as the ‘haircuts’ applied to them increased (the part that does not count as collateral). Since the supply of national “green” government bonds is still limited, it also suggests shifting the focus of the PSPP toward supranational issuers (such as the EU, for example).
The fine print of the mandate
We must see the divergent views of the ECB and the Fed primarily against the backdrop of their respective mandates. They differ on an important point. The Fed objective is to pursue price stability, maximum sustainable employment and moderate interest rates. Other social objectives, however noble, are not mentioned. For the ECB, the mandate is not only broader but also vaguer. Provided that price stability is achieved, the ECB has the secondary objective of supporting the general economic policies of the EU. Thus, according to the EU treaty, this can in principle include the “protection and improvement of the quality of the environment.”
Thus, according to the ECB mandate, there should never be a trade-off between price stability and a secondary objective. Subject to this, the mandate does in principle leave room to support the EU’s overall climate policy. In itself, this seems innocuous, but it does raise the question of who exactly sets the criteria and parameters for such monetary measures. It seems rather a task for elected policymakers. After all, these are potentially far-reaching interventions in sectoral financing and capital allocation (see also KBC Economic Opinion of 24 October 2019). Moreover, the ECB mandate calls for the ECB to act in line with the principle of an open market economy with free competition.
‘Mission creep’ by ECB ?
Moreover, another more fundamental question arises. If the green transition is supported as a secondary objective, why exactly does this not also apply to other EU policies, such as poverty reduction or security, for example? Who determines that broader monetary policy mix? Such a choice is inherently political and makes the ECB a political policymaker by the back door.
Ultimately, that dilemma was created by the wording of the mandate in the EU treaty. The ECB will have to live with it and find a politically difficult balance. The one thing that is clear from the treaty is that the ECB must under all circumstances prioritize its primary objective, which is price stability.