Global | Central banks and climate change: neither activism nor indifference

Climate change conditions how central banks manage monetary policy, but that does not mean they must become climate activists. Just as the impact of taxes, public spending, or structural reforms on inflation and activity doesn't lead monetary authorities to decide on those policies. That responsibility ultimately falls on society through its legislative and executive branches. However, central banks cannot ignore its consequences: both climate change and mitigation and adaptation policies modify the economic environment in which they must fulfill their mandate.

The reason is simple: both physical climate events and measures to promote the transition to a lower greenhouse gas emission economy can affect inflation, production, financial conditions, and the transmission channels of monetary policy. They can also alter more structural factors, such as the natural interest rate (the one consistent with stable inflation and sustained growth), and above all, inflation expectations.

For example,  droughts or heatwaves can reduce production and raise prices or increase their volatility. Floods and tropical storms can destroy capital and infrastructure, although their aggregate impact will depend on factors like insurance coverage, fiscal support for reconstruction, or the productive structure of the affected economy.These damages are compounded by supply chain disruptions, the movement of workers between regions and sectors, asset value losses, and credit restrictions.

From a monetary policy perspective, the fundamental questions remain the same. In response to any shock, a central bank must assess (within its mandate) how it will affect inflation and economic activity, how long its effects will last, and how they will spread across the rest of the economy. The difference is that climate change is making these disruptions increasingly frequent, more severe, and, moreover, of uncertain persistence, thereby complicating the assessment of their relevance for monetary policy.

The key is distinguishing between a one-off price increase and a more persistent inflationary process. If a climate-related event temporarily pushes up food or energy prices, while inflation expectations remain well anchored, the central bank may choose not to respond. However, this strategy becomes less  appropriate when shocks are severe, occur repeatedly , or end up passing through to wages, corporate pricing decisions, and, ultimately, medium-term inflation expectations. The more recurrent and persistent these shocks are, the harder it will be to treat them as merely transitory phenomena.

Climate transition policies themselves can also create a dilemma in terms of monetary policy. Carbon pricing and other mitigation measures raise the cost of fossil fuel-intensive activities and can increase headline inflation in the short term, particularly through the energy component. At the same time, they can weaken investment and activity in the short or medium term, as part of the existing capital loses profitability and reallocation towards new technologies has adjustment costs. Central banks are therefore faced with a situation in which inflation raises while economic activity weakens.

However, this  outcome is not inevitable. It depends to a large extent on the design of public policies. There is an important difference between returning revenues from carbon pricing to households through transfers that offset its regressive effects,  and using those revenues to subsidize firms’ green investment,reducing the higher upfront cost of cleaner alternatives. How these revenues are used shapes both the economic cost of the transition and its impacton prices.

The structure of each economy also matters. In an oil-exporting country, for example, a decline in demand for fossil fuels can reduce export revenues and lead to a  depreciation of the currency, amplifying  imported inflation. For this reason, evaluating  the macroeconomic consequences of the transition  requires more than simply knowing the emission reduction target: it also requires analysing the full set of instruments to achieve it.

Credibility is probably the most important link between climate policy and monetary policy. When the transition follows a predictable, gradual, and credible path; households, businesses, and markets can better anticipate its effects. Companies redirect their investments sooner toward cleaner alternatives, prices incorporate the planned measures, and the economic adjustment is smoother. By contrast, if policies come as a surprise or are perceived as lacking credibility, these decisions are postponed, and the impact on prices is likely to be greater.

So, what should central banks do? First, incorporate climate-related variables into their forecasts: physical risks, energy and food exposure, insurance, fiscal response, carbon prices, subsidies, and regulation. Second, regularly use alternative scenarios, because climate risks are uncertain and difficult to represent using historical averages. Third, communication is crucial; they must clearly explain when a rise in prices  is temporary and when it threatens to become persistent inflation.

Climate change does not invalidate current monetary theory, but it does transform the nature of the shocks central banks face. The appropriate response is not to expand their mandate to steer the transition, but to build a more climate-aware macroeconomic framework: improving forecasting models, evaluating scenarios, protecting inflation expectations, and communicating precisely when it is best to wait and when action is necessary.