A new purpose for central banks?

I have been pretty outspoken about my views that central banks have essentially made themselves redundant due to zero interest rates policies and QE. I think the only purpose left for central banks is as a lender of last resort to bail out banks and businesses in times of crisis.

But there may be a way for central banks to gain back some of their influence on the economy and inflation. We know that central banks in more and more countries engage in macro-prudential policies and, for example, require additional bank reserves for mortgage lending to ensure the property markets don’t end up in a bubble.

As we fight the climate crisis, it is increasingly obvious that we need to introduce mandatory carbon pricing of some sort or another. And this is where central banks could play a pivotal role. By asking for an anticyclical capital buffer from banks based on the carbon footprint of the companies they lend to one could keep the cost of capital low for green industries and increase it in a targeted way for polluters. It would effectively allow central banks to cool down economic activity without having to curb inflation. What the anticyclical capital buffer would do is curb inflation in the sectors and industries that are affected by it, while at the same time redirect capital and growth to green industries. This, in turn, would likely spur employment, wage growth, and potentially inflation in green sectors.

Of course, it’s a big if, because it is unclear that these measures would truly have a limited effect on inflation but a significant effect on growth. However, it seems as if such a carbon tax can act as a curb on growth when applied cyclically. A study by the European Central Bank recently looked at the impact of a broadly applied carbon tax on emissions on growth and showed that the optimal tax would be procyclical like the proposed capital buffer. The advantage of a straight carbon tax would of course be that it could be levered directly at the source (i.e. companies) rather than relying on banks who lend to these companies. But the disadvantage of a tax is that it is a political instrument and thus subject to a lot of lobbying. By handing the responsibility for the optimal price of carbon to an independent central bank we could possibly give central banks a new purpose while avoiding political cow-towing around a carbon tax.

Optimal carbon tax over the cycle (backtest)

Source: Jaccard et al. (2020).