Energy, inflation, and the impotence of the European Central Bank

This is the blog version of episode 12 of The Finrestra podcast: “What can the ECB do when inflation is driven by energy costs? Three proposals” (listen on Spotify, Apple Podcasts or YouTube).

Euro area inflation was estimated at 5.1% in January 2022. That’s mainly due to energy costs. Furthermore, businesses will try to pass on their higher costs (transport, heating, materials) to consumers.

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According to Isabel Schnabel, “Monetary policy cannot reduce the price of oil or gas.

I disagree, as I told the ECB back in 2020. If instead of government bonds, the ECB had bought a controlling stake in oil & gas majors, it could force them to lower prices.

That’s probably too radical for conservative central bankers.

But there are other, more conventional paths.

Energy makes up about 11% of Eurostat’s basket of harmonized index of consumer prices.

File:Weights of the main components of the euro area HICP (‰) - 2022 (estimated).png

What if that percentage was lower? Volatile (fossil) energy prices would have less of an effect on inflation. This would make the ECB’s job easier.

To be clear, I’m not suggesting that the ECB interferes with how Eurostat measures inflation.

Rather, the central bank could reduce our dependence on (fossil) energy.

How? Years ago, in 2017, I wrote a proposal for green investments in Europe. A European Green Infrastructure Company (EGIC) would install solar panels, build energy-efficient schools, networks of charging stations for electric vehicles… All of this infrastructure would be funded by the ECB. Why? It’s hard to imagine now, but we’ve had years were inflation was too low, i.e. below the target of the ECB. In my proposal, the EGIC would build in countries with low inflation and high unemployment. In case of the economy is overheating, new projects would be put on hold, so real resources like workers, machines and building materials can be used elsewhere in the economy.

If the EU had done this, there would be an abundance of renewable energy. This would price fossil fuels out of the market, making international energy prices almost irrelevant for European inflation.

Of course, in the real world EU politicians and central bankers have wasted the opportunity of low inflation and low interest rates.

But it’s never too late. Even without a European Green Infrastructure Company, the ECB can reduce the weight of (fossil) energy in consumers’ expenditure. High energy prices make it attractive to make buildings more energy efficient. In fact, central bankers like Isabel Schnabel have argued that the slow transition to a carbon-neutral economy is a market failure (see also this video).

The ECB could correct this market failure by making loans for energy-efficiency cheaper, for example by charging a negative rate of -5%. Banks would pass this on homeowners and landlords. At the same time, the ECB could raise rates on other loans. This would stimulate investments in building improvements, and reduce the demand for consumer loans. Companies would respond by increasing the production of building materials. It would also alleviate the labor shortage, because workers would be attracted by higher wages in the renovation business relative to other jobs.

Further reading:

The ECB can help fix the energy price crisis: Play the long game

Inflation: raising rates is not the answer

Are higher interest rates going to crash the economy? A quick calculation suggests no

Even with inflation at 5%, some people believe that higher interest rates will crash the economy. Is this 2011 all over again1?

As I explained on Twitter, increases in debt servicing costs are small compared to rises of other production costs (e.g. labor). So if the economy does crash after rate hikes, it must be because of some other/indirect cause.

Banking on YouTube

I’m trying something new. I’ve started making videos about banking, monetary policy and sustainable finance.

I’m still trying to figure out the best format. But I already like the ability to use graphs and pictures. Compared to blogging, video is less nuanced. For example, you can’t link to all sources. But maybe that’s an advantage.

Here’s the first one, let me know what you think!

Is climate change the job of central banks?

Background literature:

  • Conny Olovsson (Riksbank) argues that “monetary policy does not have the appropriate tools for counteracting global warming, but global fiscal policy is significantly better suited for this purpose.”
  • Isabel Schnabel (ECB) argues that climate risks are mispriced by financial markets. Central banks should not sustain market failures.
  • The fraction of bonds issued by carbon intensive companies in the ECB’s CSPP portfolio and accepted as collateral is far larger than the GVA of these companies, see e.g. Matikainen (figure 3) or Dafermos (figure 4).
  • Paris Agreement, Article 2, 1(c): This Agreement, in enhancing the implementation of the Convention, including its objective, aims to strengthen the global response to the threat of climate change, in the context of sustainable development and efforts to eradicate poverty, including by: Making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.
  • The European Green Deal is a priority of the European Commission.
  • Lagarde has said climate change is the job of the ECB: “[w]hether climate change (…) is to be considered as part of our primary objective. And the answer is yes.” (1:44)
  • A green mandate for the ECB? Dirk Schoenmaker says yes, Hans Peter Grüner says no.

Central bank mandates

In their paper Against amnesia: re-imagining central banking, Benjamin Braun and Leah Downey describe the elite consensus on central banking as a ‘holy trinity’. This holy trinity consists of (1) an independent central bank that (2) sets the short term interest rate to (3) achieve stable prices1.

The fact that quantitative easing (QE) is still often called unconventional monetary policy speaks volumes for how deeply the holy trinity is ingrained in the minds of the community. However, more and more people are questioning this model of central banking2.

Central bankers are almost begging politicians to spend more. A formal framework for fiscal and monetary coordination would do away with the fiction3 of central bank independence.

There’s an explosion of ideas for new instruments, from yield curve control to canceling debt to green TLTROs.

While almost nobody wants to ditch price stability, central bankers are taking on extra responsabilities based on local sensitivities. European central bankers (both at the ECB and the Bank of England) are making their institutions climate friendly. The Federal Reserve has had a dual mandate of price stability and full employment for a long time. The Reserve Bank of New Zealand will take house prices into account.

Although central banking post-holy trinity will have its own challenges, I, for one, welcome our central bank overlords.

Links spring 2021

Quantitative Easing Q&A

Who sold their bonds to the ECB?

Mainly non-resident investors, although there are national differences, as this graph by Marcello Minenna shows:

What did companies do with the money from the ECB?

Corporates used the attracted funds mostly to increase dividends, according to research by Karamfil Todorov.

Did QE ease financial conditions?

Yes. Karamfil Todorov found that the ECB’s Corporate Sector Purchase Programme (CSPP) “increased prices and liquidity of bonds eligible to be purchased substantially”1.

Can we trust central bank research on the effect of QE?

Central bank researchers face strong incentives to be positive on QE. Brian Fabo, Martina Jančoková, Elisabeth Kempf and Ľuboš Pástor found that “central bank papers report larger effects of QE on output and inflation. Central bankers are also more likely to report significant effects of QE on output and to use more positive language in the abstract. Central bankers who report larger QE effects on output experience more favorable career outcomes.”

Green finance

Asset managers, bankers, central bankers1… Everybody in finance is talking about climate change and sustainability.

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But what do green investments mean in practice?

A report by Common Wealth found that some climate-themed funds invest in oil & gas companies such as ExxonMobil. More broadly, the largest holdings of climate funds were Big Tech and finance. Adrienne Buller, the author of the study, writes “what do these ostensibly climate-focused funds really contribute to combatting the climate crisis, reducing emissions or driving a rapid transition to low carbon economic activities? There is nothing in the specific labelling or remit of these funds that would require them to invest in the green economy, in financial instruments design to drive the transition of business models to lower carbon activities, or other similar investments.” (emphasis mine)

Source: Common Wealth

There are plenty of metrics by which providers assess climate risk. Given different methodologies and the complexity of estimating climate risk, there is some divergence in the metrics. However, Chiara Colesanti Senni and Julia Anna Bingler do find that “metrics tend to converge for companies that are most and least exposed to climate risk”.

Data and tools for monitoring climate change and financial assets:

Organizations promoting green finance:

Organizations advocating broader economic change, including green finance: