Central Banks and the Fight Against Climate Change

Central banks are shifting policy regimes to incorporate environmental and social issues, moving beyond the traditional mandate of "stable prices" established in 2000.

• The Bank of England included climate change in its policy remit this year.
• The Bank of International Settlements reported that central bank governors discussing green finance rose from four in 2018 to 13 last year.

Central bank actions regarding climate change span a spectrum from risk management to active market correction.

• Protective measures: Mandating greater climate risk disclosure; a 2024 ECB survey found only 3% of 125 banks could disclose on every climate risk category.
• Proactive measures: Conducting climate stress tests and scenario analysis.
• Market neutrality deviations: Varying capital requirements and asset purchases based on environmental profiles; Sweden's Riksbank commits to purchasing corporate bonds only based on sustainability.
• The ECB is expected to make climate change a prominent feature of its upcoming strategy review later this year.

Regarding social issues, the U.S. Federal Reserve (Fed) is leading in redefining mandates to address inequality.

• President Biden called for the Fed to target racial gaps in jobs, wages, and wealth.
• The Fed's new framework redefines "maximum employment" as an inclusive goal considering race, gender, age, income, and education.
• This shifts focus from aggregate unemployment rates to specific gaps, such as the 1.8% Black-white unemployment gap recorded in August 2019.

Significant disagreements exist regarding the scope of central bank authority.

• Critics warn of "mission creep," arguing central banks should not correct market failures or constrain investment universes via negative screens.
• Concerns exist that linking capital requirements to long-term climate risks could conflict with short-term policy stances.
• A divergence is noted on easy monetary policy: while it may narrow earnings gaps, it can widen wealth gaps by driving asset price appreciation that bypasses median Black households.
• ECB President Christine Lagarde counters criticism by stating that addressing these issues is an acknowledgment of reality, not mission creep.

Institutional cooperation is accelerating to handle these complex challenges.

• The Network for Greening the Financial System (NGFS), a consortium supporting Paris climate goals, doubled its membership in the past two years.
• The Fed joined the NGFS in December.
• Central banks are increasingly required to partner with climate scientists, integrating climate models with economic models.

Investment landscape implications include prolonged dovish policies and pricing climate risks into financial assets.

• The Fed's broader labor market goals suggest rate hikes are a distant prospect.
• Asset pricing may increasingly reflect sustainability profiles, mirroring the valuation differences seen between QE-eligible and ineligible bonds.
• Wider adoption of green quantitative easing could accentuate valuation disparities based on corporate environmental profiles.

Market expectations for the Fed's policy normalization timeline.

• The Fed may begin discussing the tapering of asset purchases this summer pending positive economic data.
• Actual tapering of asset purchases is expected at the turn of the year.
• This outlook remains contingent on fiscal developments and the pace of economic recovery.