Climate Change and the Federal Reserve

To help foster macroeconomic and financial stability, it is essential for Federal Reserve policymakers to understand
how the economy operates and evolves over time. In this century, three key forces are transforming the economy: a
demographic shift toward an older population, rapid advances in technology, and climate change. Climate change has
direct effects on the economy resulting from various environmental shifts, including hotter temperatures, rising sea
levels, and more frequent and extreme storms, floods, and droughts. It also has indirect effects resulting from
attempts to adapt to these new conditions and from efforts to limit or mitigate climate change through a transition to
a low-carbon economy. This Economic Letter describes how the consequences of climate change are relevant for
the Fed’s monetary and financial policy.

Climate change and the transition to a low-carbon economy

Surface temperatures were first regularly recorded around the world in the late 1800s. Since then, the global average
temperature has risen almost 2°F (Figure 1) with further increases projected (IPCC 2018). Based on extensive
scientific theory and evidence, a consensus view among scientists is that global warming is the result of carbon
emissions from burning coal, oil, and other fossil fuels. Indeed, as early as 1896, the Swedish chemist Svante
Arrhenius showed that carbon emissions from human activities could cause global warming through a greenhouse effect.
The underlying science is straightforward: Certain gases in the atmosphere, such as carbon dioxide and methane,
capture the sun’s heat that is reflected off the Earth’s surface, thus blocking that heat from escaping into space.
These greenhouse gases act like a blanket around the earth holding in heat. As more fossil fuels are burned, the
blanket gets thicker, and global average temperatures increase. Other empirical measurements have confirmed many
related adverse environmental changes such as rising sea levels and ocean acidity, shrinking glaciers and ice sheets,
disappearing species, and more extreme storms (USGCRP 2018).

Climate change also affects the U.S. economy. The latest National Climate Assessment, a 1,515-page
scientific report produced by 13 federal agencies as required by law, summarized this impact:

Without substantial and sustained global mitigation and regional adaptation efforts, climate change is
expected to cause growing losses to American infrastructure and property and impede the rate of economic growth over
this century (USGCRP 2018, pp. 25–26).

Economists view these losses as the result of a fundamental market failure: carbon fuel prices do not properly
account for climate change costs. Businesses and households that produce greenhouse gas emissions, say, by driving
cars or generating electricity, do not pay for the losses and damage caused by that pollution. Therefore, they have no
direct incentive to switch to a low-carbon technology that would curtail emissions. Without proper price signals and
incentives in the private market, some kind of collective or government action is necessary. One solution would be to
charge for the full cost of carbon pollution through an extra fee on emissions—a carbon tax—that would account for the
costs of climate change on the economy and society. Many leading economists are calling for a carbon tax to correct
market pricing (Climate Leadership Council 2019, Fried, Novan, and Peterman 2019).

A carbon tax that is set at the proper level can appropriately incentivize innovations in clean technology and the
transition from a high- to a low-carbon economy. Such a carbon tax should equal the “social cost of carbon,” which
measures the total damage from an additional ton of carbon pollution (Auffhammer 2018). A crucial consideration in
calculating this cost is that carbon pollution dissipates very slowly and will remain in the atmosphere for centuries,
redirecting heat back toward the earth. Consequently, today’s carbon pollution will create climate hazards for many
generations to come. A second difficulty in calculating the social cost of carbon is tail risk, namely, the
possibility of catastrophic future climate damage (Heal 2017). A final complication is that the causes and
consequences of climate change are global in scope. The resulting intergenerational and international market failure
is so problematic that some economists doubt that a carbon tax alone would suffice (Tvinnereim and Mehling 2018).
Instead, a comprehensive set of government policies may be required, including clean-energy and carbon-capture
research and development incentives, energy efficiency standards, and low-carbon public investment (Gillingham and
Stock 2018).

Climate change and the Fed

Given the role of government in addressing climate change, how does the Federal Reserve fit in? In particular, how
does climate change relate to the Fed’s goals of financial and macroeconomic stability? With regard to financial
stability, many central banks have acknowledged the importance of accounting for the increasing financial risks from
climate change (Scott, van Huizen, and Jung 2017, NGFS 2018). These risks include potential loan losses at banks
resulting from the business interruptions and bankruptcies caused by storms, droughts, wildfires, and other extreme
events. There are also transition risks associated with the adjustment to a low-carbon economy, such as the unexpected
losses in the value of assets or companies that depend on fossil fuels. In this regard, even long-term risks can have
near-term consequences as investors reprice assets for a low-carbon future. Furthermore, financial firms with limited
carbon emissions may still face substantial climate-based credit risk exposure, for example, through loans to affected
businesses or mortgages on coastal real estate. If such exposures were broadly correlated across regions or
industries, the resulting climate-based risk could threaten the stability of the financial system as a whole and be of
macroprudential concern. In response, the financial supervisory authorities in a number of countries have encouraged
financial institutions to disclose any climate-related financial risks and to conduct “climate stress tests” to assess
their solvency across a range of future climate change alternatives (Campiglio et al. 2018).

Some central banks also recognize that climate change is becoming increasingly relevant for monetary policy (Lane
2017, Cœuré 2018). For example, climate-related financial risks could affect the economy through elevated credit
spreads, greater precautionary saving, and, in the extreme, a financial crisis. There could also be direct effects in
the form of larger and more frequent macroeconomic shocks associated with the infrastructure damage, agricultural
losses, and commodity price spikes caused by the droughts, floods, and hurricanes amplified by climate change (Debelle
2019). Even weather disasters abroad can disrupt exports, imports, and supply chains close to home. As a much more
persistent factor, Colacito et al. (2018) found that the current trend toward higher temperatures on its own has
slowed growth in a variety of sectors. They estimated that increased warming has already started to reduce average
U.S. output growth and that, as temperatures rise, growth may be curtailed by more than ½ percentage point later in
this century.

On top of these direct effects, climate adaptation—with spending on equipment such as air conditioners and resilient
infrastructure including seawalls and fortified transportation systems—is expected to increasingly divert resources
from productive capital accumulation. Similarly, sizable investments would be necessary to reduce carbon pollution and
mitigate climate change, and the transition to a low-carbon future may affect the economy through a variety of other
channels (Batten 2018). In short, climate change is becoming relevant for a range of macroeconomic issues, including
potential output growth, capital formation, productivity, and the long-run level of the real interest rate.

Nevertheless, some view the economic and financial concerns surrounding climate change as having either too short or
too long a time horizon to affect monetary policy decisions. Indeed, at the short end, monetary policy typically does
not react to temporary disturbances from weather events like hurricanes or blizzards. However, climate change could
cause such shocks to grow in size and frequency and their disruptive effects could become more persistent and harder
to ignore. At the long end, most of the consequences of climate change will occur well past the usual policy forecast
horizon of a few years ahead. However, even longer-term factors can be relevant for monetary policy. For example,
central banks routinely consider the policy implications of demographic trends, such as declining labor force
participation, which have long-run effects much like climate change. In addition, prices of equities and long-term
financial assets depend on expected future conditions, so even climate risks decades ahead can have near-term
financial consequences. Climate change could also be a factor in achieving and maintaining low inflation. It took a
decade or two—a relevant time scale for climate change—for the Fed to achieve its inflation objective after the Great
Inflation of the 1970s and the Great Recession. Finally, the economic research that quantifies optimal monetary policy
routinely uses a very long-run perspective that takes into account inflation and output quite far out in the future.

While the effects and risks of climate change are relevant factors for the Fed to consider, the Fed is not in a
position to use monetary policy actively to foster a transition to a low-carbon economy. Supporting environmental
sustainability and limiting climate change are not directly included in the Fed’s statutory mandate of price stability
and full employment. Furthermore, the Fed’s short-term interest rate policy tool is not amenable to supporting
low-carbon industries. Wind farms in Kansas and coal mines in West Virginia face the same underlying risk-free
short-term interest rate. Instead, some have advocated that central banks use their balance sheet to support the
transition to a low-carbon economy, for example, by buying low-carbon corporate bonds (Olovsson 2018). Such “green”
quantitative easing is an option for some central banks but not for the Fed, which by law can only purchase government
or government agency debt.

Conclusion

Many central banks already include climate change in their assessments of future economic and financial risks when
setting monetary and financial supervisory policy. For the Fed, the volatility induced by climate change and the
efforts to adapt to new conditions and to limit or mitigate climate change are also increasingly relevant
considerations. Moreover, economists, including those at central banks, can contribute much more to the research on
climate change hazards and the appropriate response of central banks.

Glenn D. Rudebusch is senior policy advisor and executive vice president in the Economic
Research Department of the Federal Reserve Bank of San Francisco.

References

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