Using green credit policy to bring down inflation: what central bankers can learn from history

INSPIRE Sustainable Central Banking Toolbox – Policy Briefing No.13

Central banks typically associate climate-supporting measures with an expansionary monetary policy stance. Such measures are therefore thought to be inappropriate in an inflationary context.

However, central banks can design green credit policy instruments to potentially bring down inflation while also making allocative choices in support of the low-carbon transition.

This paper draws on examples of policy made at the German Bundesbank and other central banks which sought to protect some sectors during a tightening cycle in ways that are compatible with market liberalism and central bank independence.

Key messages

• Action taken by central banks to fight inflation is widely considered to contradict their role in supporting the transition to a sustainable, low-carbon economy. A sharp rise in interest rates would disincentivise investments in clean energy production, energy efficiency and adaptation to climate change.
• There are several reasons for central banks to use green credit policy in an inflationary context:
  • A lack of sufficient green investment is undesirable in terms of ensuring long-term price stability.
  • The high upfront costs associated with renewable energy production and infrastructure makes them particularly sensitive to interest rates.
  • Monetary policy that seeks to bring down inflation in the short term by restricting investments in climate mitigation would make the global economy more vulnerable to future climate- and biodiversity-related economic shocks, including adverse shocks to price stability.
  • A lack of green investment would also expose the domestic economy to stronger price shocks to high-carbon energy or other goods whose production is affected by ecological transformation.
  • The failure of central banks to consider the environmental impact of their instruments can undermine the broader role for monetary policy in supporting financial stability, government economic policy, stable employment and other central bank objectives.
• Making selective exemptions at times of monetary tightening is neither new nor unorthodox: the Bundesbank and the Banque de France would selectively exempt crucial sectors from credit restrictions until the late 1990s.
• There are many direct and indirect ways in which central banks can shape the allocation of credit in the economy in a way that aligns with the sustainable transition. For example: lending to an investment bank or government vehicle, or creating a special status for debt guaranteed by these institutions; green refinancing credit; green asset purchase programmes; and green reserve requirements.
• Giving priority to certain investments through targeted central bank refinancing is compatible with central bank independence and current mandates. Yet, the democratic legitimacy of green credit policy requires stronger coordination with executive bodies, parliamentary oversight and central bank accountability.

This paper is part of the INSPIRE Sustainable Central Banking Toolbox, which is designed to support central bankers and financial supervisors in calibrating monetary, prudential and other instruments in accordance with sustainability goals as they address the ramifications of climate change and other environmental challenges. The papers have been written and peer-reviewed by leading experts from academia, think tanks and central banks and are based on cutting-edge research, drawing from best practice in central banking and supervision.