The role of monetary policy during a low-carbon transition

The low-carbon transition has key implications for monetary policy as central banks face a trade-off in meeting objectives on inflation and output when responding to negative supply shocks. This study models the macroeconomic impacts of a 2°C scenario and provides insights into monetary policy actions under such a scenario using the multi-region, multi-sector model of the global economy G-Cubed. We begin by estimating the impacts across global regions and sectors under a Henderson-McKibbin-Taylor (HMT) rule and then consider the impacts when central banks follow alternative rules, by either placing more weight on inflation or output growth. Finally, we explore the monetary policy implications of a carbon tax implemented alongside a government spending shock to low-carbon infrastructure which boosts productivity. We find that when following an HMT rule, central banks respond in the near term to higher inflation by raising policy rates but ease in the medium- to long-term as the negative impact on output growth offsets that on inflation. Interest rates remain much lower than baseline in the long term, suggesting that the high adjustment costs associated with the transition will lead to a reduction in the neutral interest rate. As expected, the impact on inflation is lower under an inflation-targeting regime and the impact on output is less negative under an output-targeting regime.

This research highlights a number of implications for policy in facilitating the transition. First, central banks should consider the trade-off in raising interest rates following a temporary supply shock if they will likely need to ease rates in the future (in other words, there is a case to ‘look through’ the inflation increase). In addition, there is a potential role for monetary and fiscal policy coordination. In particular, government spending on low-carbon infrastructure could assist in limiting the near-term negative impact on growth and facilitate a longer-term increase in productivity. However, given the large productivity improvements required to offset the negative impact of the shock, independent improvement in low-carbon technologies would likely also be needed.