America’s central bank continues to ignore climate risk
Around the world, central banks have started adapting their policies and frameworks to address the profound implications of climate issues on inflation. However, the US Federal Reserve is lagging far behind its peers.
As the European Central Bank (ECB) increasingly positions its climate and nature agenda as part of its core price stability remit, the Fed continues to delay starting to account for climate in its inflation management, risking declining relevance in a sustainability-driven financial future.
Climate change and volatile fuel prices are taking a rising economic toll
Extreme weather is now costing the US approximately $1 billion every three weeks, and evidence shows the nation’s dependence on volatile fossil fuel markets is destabilizing the economy and driving up inflation.
Critics point out that while the Fed stalls on climate action, the economic toll is only rising.
The risk of a disorderly transition is growing rapidly, raising the possibility of a system-wide disaster exceeding the scale of the 2008 global financial crisis.
Changing weather patterns are disrupting the real estate market as insurance premiums skyrocket along with rising wildfire and flood risks. Extreme weather has forced global food prices up following disruptions to the agricultural sector. And the risk of a disorderly transition is growing rapidly, raising the possibility of a system-wide disaster exceeding the scale of the 2008 global financial crisis.
For the Fed to fulfill its primary mandate, it should facilitate a rapid and orderly transition away from inherently volatile fossil-fuel markets towards more stable electrical and renewable sources, economists from the Roosevelt Institute argue.
The domino effect: consequences of Fed’s lack of credible climate leadership
While the ECB has become a climate leader, “the Fed failed to consider climate change in any meaningful way,” say the authors of a working paper published last year by the Hutchins Center on Fiscal and Monetary Policy at The Brookings Institution. Not only is the Fed ignoring its core priorities by failing to address the impact of climate on prices, employment, and output, it is also holding back globally coordinated climate action.
“The deeply polarized and partisan U.S. debate on climate change, stoked by an influential domestic fossil fuel industry, [has] led the Fed to adopt only a modest version of the foundational climate norms — a stark divergence from the proactive climate stance of the ECB,” the researchers conclude.
Banks are struggling to implement the final stages of the Basel III international capital accord, known as the Basel III Endgame. US banking regulators, particularly the Fed, are also reportedly blocking important actions at the Basel Committee on Banking Supervision to address the financial risks posed by climate change.
That “the US has gone from leaders to laggards in both standard-setting and implementation — is striking”, wrote Graham Steele, the former Assistant Secretary for Financial Institutions at the US Department of the Treasury, in Green Central Banking. The Fed ranks 16th out of 20 major central banks in the Green Central Banking Scorecard, with a score of D-, making it the worst performer among G7 economies.
The Fed ranks 16th out of 20 major central banks in the Green Central Banking Scorecard, with a score of D-, making it the worst performer among G7 economies.
Fed officials have argued these climate proposals are outside the realm of finance, with Fed chairman Jerome Powell arguing elsewhere that the Fed shouldn’t be mistaken for a “climate policymaker.”
This distaste for integrating climate risk into central bank policy and regulation also means that the Fed, unlike peers such as the ECB, the People’s Bank of China, and Bank of Japan, lags behind in developing proper tools and green finance incentives. This absence of direct financial incentives from the world’s most influential central bank is slowing the redirection of capital towards the global green transition and may signal a lack of urgency to other central banks.
Although the Fed has made initial progress to improve its climate risk analysis, for instance by conducting a pilot climate scenario analysis exercise in 2023, the exercise was criticized for its limited scope and lack of transparency.
These lackluster results “demonstrate how much work the US still has to do just to understand the scope of the problem” and implement “basic risk management frameworks,” said Steele.
Fed’s response to climate-related inflation may undermine its global influence
Evidence is piling up that a clean energy transition is crucial to managing inflation. Researchers anticipate escalating environmental shocks, alongside related crises such as bottlenecks in the critical materials needed to scale renewable energy, will likely cause substantial supply-side disruptions with inflationary consequences.
If such pressures arise, the Fed should “look through” these transitory supply-side shocks and refrain from raising interest rates, say David Barmes and Simon Dikau, researchers at London School of Economics and Political Science (LSE).
The climate consequences of rate hikes
Rate hikes are blunt monetary tools that seek to reduce inflation resulting from an overheated economy by dampening aggregate demand. They are intended for situations where economic activity and inflation are “moving in the same direction.” They will do little to address inflation caused by a lack of supply-side resilience, Barmes, policy fellow LSE’s Grantham Research Institute and specialist in sustainable central banking, told Climate & Capital Media.
Evidence is piling up that a clean energy transition is crucial to managing inflation.
“If the Fed continues to hike rates in response to those shocks, we’re essentially going to have a situation where it is repeatedly contracting demand in response to shrinking supply,” he said.
Additionally, by making upfront investments needed to scale renewable energy infrastructure more expensive, higher rates can exacerbate two significant drivers of contemporary inflation trends — fossil fuel dependency and climate change.
In the dollar-dominated international financial system, the Fed’s actions reverberate globally.
However, according to Barmes and Dikau, examining supply shocks on a global scale is currently not possible without the Fed’s cooperation.
If the Fed hikes rates, other central banks would be forced to follow suit to prevent capital flight and currency depreciation, even if such actions undermine their efforts to transition to a more climate-resilient economy and exacerbate debt distress.
As a result, “governments’ borrowing costs go up, and their fiscal space is constrained for both adaptation and mitigation,” leading to “a potentially catastrophic scenario,” said Barmes.
Major reforms needed
While green-targeted lending schemes can insulate private green investment from rate hikes, public investments, particularly in the Global South, are highly vulnerable to rising borrowing costs.
Consequently, Barmes and Dikau contend that truly sustainable central banking may necessitate “major reforms to the international monetary and financial system,” particularly if the Fed is unwilling to frequently look through inflationary pressures caused by climate change.
Regional payment systems and central bank digital currencies have been put forward by some as possible measures worth exploring to reduce dependence on the US dollar system and increase monetary sovereignty for other nations.
Charting a new course: a holistic approach to inflation management
From an international perspective, the Fed should take the media response to its disruptive role at Basel as a “wake-up call,” said Steele, and “stop obstructing the countries that are leading the way in our absence and reclaim a position of global leadership.”
The Fed, says Steele, should adopt a more holistic climate-informed approach to inflation management.
The Fed’s reluctance to embrace climate as a critical financial risk carries a substantial risk to the role of the US dollar as the global fiat currency.
According to Barmes, there is “certainly a pathway” for the Fed to adapt its analytical tools to better account for how climate change and other environmental factors affect prices.
This could include examining transition-related supply-side shocks, incorporating climate into inflation forecasting, developing climate-aware macroeconomic models that account for significant price volatility, and exploring alternative green policy tools.
The Fed’s reluctance to embrace climate as a critical financial risk carries a substantial risk to the role of the US dollar as the global fiat currency. Unless the Fed abandons its outdated approach to climate, initiatives to de-dollarize the global economy, once thought unfeasible, may eventually be viewed as more viable than waiting on action from the Fed in, what U.N. Secretary-General Antonio Guterres described as, an “era of global boiling.”
