Green transition and monetary policy

Key points:

  • Watching the wavelets: while the dataflow is inconclusive, investors and central banks are still waiting for signals from Mr Trump and Mr Xi.
  • Monetary policy and climate change: beyond the "greening" of central banks' operational framework, the transition to a cleaner growth model is a challenge for monetary policy. We focus here on the mechanics of a negative supply-side shock.
  • Tiering is not that bad: the latest data suggests Northern banks are lending to their Southern counterparts, a crucial development to make "tiering" work.


Watching the wavelets

Jay Powell’s congressional hearings confirmed the US Federal Reserve (Fed) is looking for a pause. Even central bankers are entitled to a quiet Christmas season. However, his tone was very cautious and it is clear to us that the Fed has its “finger on the trigger”: it would not take much of a deterioration in the dataflow, especially since inflationary pressure remains remarkably muted, for them to cut further. In our view, the Fed is in a “conditional pause”. It is not “done”. That is how we understand Powell’s point on “policy is not on a pre-set course”.

Another interesting takeaway from the hearings is that just like in Europe it is becoming increasingly difficult for the US central bank not to comment on fiscal policy. In his prepared statement Jay Powell mentioned the fact that fiscal policy would have to be involved in dealing with an economic downturn – echoing Mario Draghi’s “last message” as President of the European Central Bank (ECB) – but also seized upon the recent outlook from the Congressional Budget Office suggesting the US federal budget is on an “unsustainable path”.

If more deficits would be unsustainable, it is unclear how fiscal policy could respond to an imminent slowdown – unless the Fed is ready to help keep the government’s funding costs low. This gets us back to the theme of “fiscal dominance” which we think is now present, to varying degrees, across the developed world. Central banks can no longer add much stimulus on their own, but at least maintaining the already accommodative monetary policy stance is a pre-condition for any active fiscal policy.

Beyond the dataflow, it was also obvious that Powell is closely monitoring developments on the still elusive “phase one deal” between the US and China for which no date has been announced.

The Fed from this point of view is exactly in the same situation as all the other market participants: the fate of the current global cycle very much depends on whether a de-escalation in the trade war quickly materialises. Over the last two weeks the “noises” coming from the White House have been less comforting on that front. On November 8th President Trump denied he had reached a conclusion on whether to “roll-back” some of the tariff hikes implemented recently. He upped the ante on November 12th by stating he would strike with “very substantial” additional tariffs should China reject the deal. Larry Kudlow made more constructive comments last Thursday night, but finding the signal amid the noise is particularly difficult on this matter.

The centrality of the trade war issue obviously also holds for Europe as well. Germany avoided – just – a technical recession. GDP growth for the third quarter (Q3) GDP came out at +0.1%, but the downward revision to Q2 GDP (from -0.1% to -0.2%) is a useful reminder of how weak what is normally Europe’s economic engine is at the moment. The qualitative breakdown for GDP was also interesting: consumption held up, while corporate investment fell further, following the pattern we highlighted in our 28 October Macrocast. Any rebound in German investment is dependent in our view on good news on the global trade front. The recent disappointing series of data from China, with industrial production relapsing in October, is not a great signal.

Real-time economic analysis at the moment is akin to watching “wavelets” come and go, as the message from the dataflow is ambiguous ( in the US job creation has been reassuring, but the latest consumption numbers have been on the wobbly side and industrial production has remained weak), while the outcome of the real issue, whether we can count on a de-escalation of the trade war or not in 2020 , remains uncertain.

Monetary policy and climate change: a variation on a speech by Benoit Coeure

One by one they go. Last week Benoit Coeuré announced he was going to lead the innovation hub of the Bank for International Settlements after eight years at the board of the ECB. He will be sorely missed, not just for his creativity and his understanding of market dynamics, but also for his capacity to steer the economic debate. ECB watchers usually pore over every speech by board members to look for clues on the central bank’s next moves, and Benoit Coeuré’s speeches were often illuminating from this point of view. But maybe more fundamentally they were intrinsically interesting, beyond the immediate policy messages, thanks to his encyclopaedic economic – and extra-economic – culture. We want here to draw on one of his “long speeches”, the one he delivered a year ago on climate change and monetary policy.

In this speech, he touched upon the possible “greening” of the ECB’s operational framework – for instance, on the introduction of Environmental, Social and Governance (ESG) criteria in the kind of assets central banks can purchase.  This came back to the fore with the rebuke by Jens Weidmann a few weeks ago. But our attention was drawn on other aspects of his speech, particularly the impact climate change could have on the reaction function of the central bank. Benoit Coeure mentioned for instance the risk that climate change, by generating a rise in “freak” weather incidents, could make the economic data more volatile, hence making monetary policy decision-making more difficult.

His key comment though, in our view, was his point on the possibility that once renewable energies are fully mature, they could trigger a brutal decline in the price of the more traditional sources of energy. This would constitute a positive supply-side shock and as such the central bank should not be alarmed by a transitory decline in the general level of prices, but there is always the risk that a lasting fall in energy prices adds to the drop in long term inflation expectations, making the central bank’s job even more difficult.  

We think this issue – climate change as a source of supply-side shocks – is going to be crucial, but for our part we will focus here on the angle Benoit Coeuré did not discuss much, i.e the possibility that climate change triggers lasting negative supply-side shocks, as part as the transition to a less CO2-intensive model, before our economies have fully converted to a greener growth model, and where public policies intervene to force a re-allocation of consumption from CO2 intensive products towards cleaner products. The impact is ambiguous but it is likely to have at least transitorily a positive rather than a negative impact on consumer prices, accompanied potentially by a decline in the natural interest rate of the economy. We offer here a step by step, very simplified approach with an illustrative quantification.

We start with a simple model with two substitutable products, one “brown”, CO2-intensive, and the other “green”. The “brown” one is produced following an old, tried and tested dominant technology. The “green” one is produced with a new technology. The brown product is thus initially cheaper than the greener one. Think for instance of the difference in price between a traditional combustion engine car and a hybrid one. To incentivise consumers to shift towards the green product, the government should modulate the tax rate (or offer subsidies, which does not change the overall reasoning) so that its after-tax retail price is lower than that of the brown product. In the first round of our experiment, we add another constraint: that overall tax receipts are unchanged, so that the “green transition” is fiscally neutral.

For a 90% brown/10% green product mix, and a 10% pre-tax price difference between the two products, taxing the brown products at 11.2% and the green product at 0.1% equalises the price and keeps total tax receipts unchanged relative to an initial equal tax rate of 10% (Exhibit 1).

Exhibit 1 – Nudging towards “green products” with tax policy

So far so good. This is however a static approach, while the very purpose of the tax modulation is to trigger a change in the product mix. So, in a second round of the experiment we look at what happens when consumers actually react and move towards the greener option. We posit then a new product mix with a 20% share for the green product. With unchanged tax rates, the government mechanically incurs a loss in total tax receipts.

In the third and last round of the experiment (last column on the right) we change the tax rates so that government revenue is restored, while the after-tax price of the two products remains equal. The “only” problem then is that the transition cost is borne by the consumers, who end up paying a higher price for their products in aggregate (see the “total value” line in our table). In a nutshell, either the transition is paid by an increase in the government deficit, or it is paid by an increase in the general level of prices.

There is obviously a major caveat to this pessimistic line of reasoning: the pre-tax price of the green product will fall as consumption rises, thanks to economies of scale. This means that gradually the “fiscal incentive” the government will need to offer will diminish. This has already happened in the realm of fighting climate change. For instance, the price of solar panels has fallen much more quickly than expected.  Still, the net result will depend on a “race” between the effect of consumers’ price elasticity (how they reallocate their spending in response to a change in relative prices) and that of the economies of scale on the pre-tax price of the greener products. It is very difficult to assess this ex ante. Odds are the government will have to resort to some “trial and error” approach, fine-tuning the tax rates as it goes while monitoring how consumer preferences move and economies of scale kick in.

Moreover, our simplified model offers a choice between only two substitutable products. In reality, the green transition is much more complex. We can take the example of the car industry again. The choice is not just between combustion-only and hybrid engines. Full-electric cars are increasingly available, while other technologies could be developed (hydrogen engines for instance) so that calculating in advance the “right” tax policy is next to impossible.

All these sources of uncertainty may ultimately lure government towards a more “authoritarian” approach where brown products are simply banned. Such cliff edge policy would almost certainly also raise the overall level of prices since the shift would likely occur before economies of scale have had time to emerge on the green products.

None of these options would let monetary policy off the hook. If governments “internalise” the cost and allow their total tax receipts to fall, two things may happen: (i) either they keep their overall deficit targets unchanged, which means that their capacity to engage in counter-cyclical policy would diminish, leaving central banks to bear the brunt of cyclical stabilisation, or (ii) they let their overall deficits and debt levels rise, which may ultimately incentivise central banks to intervene to preserve long term debt sustainability. This is obviously not the ECB’s mandate, but we think the central bank would come under massive pressure if it refused to take into account a rise in public debt which could be identified as stemming primarily from delivering on the fight on climate change, an increasingly popular policy goal across the euro area and beyond.

If governments choose not to internalise the costs and keep their tax receipts unchanged, then the transition will for a while trigger a negative supply-side shock, with a rise in the general level of prices. Textbook monetary policy would suggest central banks should not intervene and let the “hump” in prices run its course. A problem though is that such “hump” can be persistent, and depending on where we are in the cycle at the moment it appears, second round effects may turn a transitory shock monetary policy can ignore into a more lasting trend. In a situation of overcapacity, the transition shock will have a low probability to generate a lasting inflation wave, since a decline in purchasing power is likely to dominate. If it happens in a situation of wide, positive output gap, then inflation could start accelerating “in its own right” through wage indexation for instance.

All this is not a theoretical discussion. For instance the coalition in power in Germany agreed on September 29th on a “Green package” worth EUR 50bn through 2023 which would be budget neutral (i.e entirely covered by the receipts of a carbon tax).  At 10 euro per ton the carbon tax is unlikely to have a significant impact on the cost structure of the German economy, but a recent occasional paper by the Dutch national central bank (“The price of transition”) suggested a significant impact on aggregate costs at the firm level (+0.9%) for a carbon tax at EUR 50/ton on top of existing taxation.

In addition, rather than a supply-side shock occurring at the same time across the world economy, it is likely that the green transition will take place at different moments across the main economic regions of the world, generating ripples via import prices. We also need to factor in the possibility that the EU imposes a “border tax”, dependent on the CO2 footprint of the product it imports.

Finally, central banks may be faced with a decline in the natural, or equilibrium interest rate, at least transitorily. Indeed, the internalisation of the climate change externality could force a massive re-allocation of capital and labour from “dirty”, but highly productive and profitable sectors, to “clean” but poorly productive activities before economies of scale work their magic. This would be consistent with a transitory decline in aggregate productivity and in the return on investment. These are key ingredients into a drop in the equilibrium interest rates.

Obviously, all these costs stemming from the transition to a cleaner economy are likely to be dwarfed by an “unchanged scenario” in which climate change is allowed to proceed unchecked, and here we chose a narrow angle (Pigouvian taxes are only one aspect on the green transition). But it would be risky in our view to focus on an optimistic scenario in which the transition would “pay for itself”. All key macroeconomic actors will be affected. The ECB will soon start a “strategic review”. This week Vice President de Guindos mentioned that climate change would be part of this review. This is highly warranted in our view, and this should go far beyond discussing whether or not only ESG compliant assets could enter the central bank’s balance sheet. Of course, today it is much more a “low inflation for long” scenario which dominates economic thinking and we agree this is the most pressing issue. But looking into the decade to come, we need to start thinking about positive price shocks.

Tiering is not that bad actually

After the ECB’s latest cut, we highlighted in our 30 September Macrocast the need for cash-rich banks in core countries to lend their excess reserves to Southern banks for “tiering” to be a success. Indeed, the near-entirety of the aggregate excess reserves held in the South is now exempt of the negative deposit rate “tax”. This means that Southern banks can borrow negative yielding liquidity from their Northern counterparts, keep them on their account at their national central bank and earn the carry. Northern banks are better off lending out their cash, even at a negative yield, than leaving it on their national central banks accounts where it will incur the negative deposit rate, as long as they can eke out a better “remuneration” than -0.5%.

A problem though is that since the sovereign crisis of 2012 Northern banks had become increasingly reluctant to extend credit to their peripheral counterparts. The good news is that it seems to be changing, as the improvement in the flows into the Target 2 balance of Italy shows– matched by a deterioration in that of Germany (Exhibit 2). Indeed, in practice a German bank lending cash to an Italian bank will do so by instructing the Bundesbank to credit Banca d’Italia (matched by the Bundesbank debiting the German bank account on its books and Banca d’Italia crediting the Italian bank on its books). This will generate an improvement in the net Target 2 balance of Italy. There is still a lot to do to fully normalise the circulation of liquidity in the euro area – just take a look at Target 2 in level (Exhibit 3) -  but it is definitely a positive development.

Incidentally, these movements could be a useful reminder to observers, especially in core countries, that Target 2 balances can be affected by very technical developments which have not much to do with a situation of “capital flight”. For instance quantitative easing mechanically lifts the Italian “debt” vis-à-vis Germany via Target 2 when German banks sell their Italian bonds to Banca d’Italia and repatriate the cash home.

A side-effect is that if Southern banks are incentivised to keep their cash at the central bank without incurring a negative rate they will buy less local sovereign bonds at the short end of the curve. Actually, 2-year yields have stopped being negative in Italy last week from a recent trough at -0.33% in early September. However, there has not been any clear movement towards a curve flattening during the same period (exhibit 4) and the shape of the Italian curve has changed broadly in sync with the German curve. There has not been any discernible pattern in the change of the spread between Italy and Germany during the same period (exhibit 5). We are thus less concerned with the side-effects of tiering than we were back in September, but it is an issue worth monitoring regularly.


Upcoming events

US: Mon: NAHB Housing Market Index; Wed: FOMC meeting minutes published Thu: Philadelphia Fed Index; Fri: prel. composite, manufacturing and services PMIs, Michigan consumer sentiment index
Euro Area: Mon: German PPI; Thu: ECB publishes Monetary Policy meeting minutes, Eurozone consumer confidence; Fri: Eurozone, French, German composite, manufacturing and services PMIs
UK: Tue: CBI industrial trends orders; Wed: labour productivity; Thu: public sector net borrowing, BoE MPC Treasury Committee hearings; Expected: Conservative and Labour GE manifestos published
China: Wed: PBoC decision
Japan: Tue: trade balance; Thu: CPI, prel. Manufacturing PMI

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