Central banks expanding mandates to include Climate Change and Inequality could pose their own risks — should they do it anyway?
That the Central Bank is an integral instrument of the global financial system was a truth oft tested through the course of the COVID-19 pandemic. Central Banks around the globe have spent the last year at the frontlines through the battle against the pandemic, with several policymakers and their policies surrounding credit support and rate cuts coming under scrutiny at several different points. A major topic of discussion, in this regard, was the disbursement of emergency funding and liquidity injections. Although several other global organisations such as the IMF and World Bank set out emergency funding measures (especially for developing countries), the volume disbursed by central banks all over the world was of much heftier value (such as the Federal Reserve lending up to $2.3 trillion over the course of the last few months).
Today, monetary authorities are increasingly expected to expand their agenda to cover aspects such as climate change and inequality, over objections regarding possibly losing their operational independence in the process. However, to believe that operational independence must be limited to this metric alone may not be prudent. It is crucial for even purists to observe that the role of central banks has already undergone a radical transformation.
The Global Financial Crisis of 2008 and the current COVID-19 pandemic are examples of how central banks have had to adapt to meet the needs of the economy, outside their ‘narrow’ ambit of focusing solely on price stability and inflation targeting alongside maintaining a smooth payments system. By engaging in activities such as Quantitative Easing (QE) through the purchase of government bonds, among several other instruments, central banks have already ventured outside their scope of ‘just’ interest rates and open market operations. And, interestingly, several global central banks have remained, at least operationally, independent of government control.
A Risk to Independence?
Recent calls from European Central Bank President, Christine Lagarde and US Representative of California, Maxim Waters (among several others) to expand the ambit even further have now proposed the addition of aspects such as climate change and racial inequality to central bank policymaking. This has, of course, alarmed purists, who argue that the added responsibilities will not only divert central banks and their policy instruments from their main objectives of price stability and inflation targeting, but also be rather blunt in their application to the issue at hand: proposing increased taxation on carbon emissions and developing stronger housing laws instead. The main argument against the call, however, is due to the possible negative impact on operational independence.
In spite of its operational independence, the efficacy of central bank policies is judged on whether or not targets for specific mandates are achieved. An expanded central bank mandate will not only greatly complicate the relationship between specific policy instruments and targets, but also make performance justification harder, especially if the mandated (and independently verifiable) targets are missed.
According to American economist Barry Eichengreen: “Success or failure would be more difficult to judge. Indeed, insofar as monetary policy has only limited influence over climate change or inequality, targeting such variables would be setting up the central bank to fail. And frustration over failure might lead politicians to rethink the central bank’s operational independence.”
A View on an Expanded Policy Mandate
In such a scenario, and given the fact that these are not issues that central banks can simply turn a blind eye to, the only solution would be to find a path where policies can be effectively carried out without posing a risk to independence. When discussing the aspect of climate change, Czech-based Project Syndicate writes: “Central banks as regulators have tools with which to address climate change, and their responsibility for ensuring the integrity and stability of the financial system gives policymakers the mandate to use them. They can require more extensive climate-related financial disclosures. They can impose stricter capital and liquidity requirements on financial institutions whose asset portfolios expose them to climate risk. Such tools will discourage the financial system from underwriting brown investments.”
While the aforementioned may indeed prove to be beneficial, the biggest challenge will be to maintain financial stability — especially given the fact that the risks posed by climate events are nonlinear and irregular in nature. With mistakes made in the modelling (or lack, thereof) of the COVID-19 crisis kept in mind, there must be a call to unify central bank professionals with scientists involved in the study of climate change as soon as possible.
In the case of tackling issues posed by inequality, several global central banks have already been proactive in setting up new mandates. According to Eichengreen, “In the United States, the Community Reinvestment Act of 1977 tasks regulators, including the Fed, with ensuring that low- and moderate-income families have adequate access to credit. The Fed has delegated this responsibility to its 12 regional reserve banks, each of which fulfils it in different ways. Stronger guidance from the Federal Reserve Board on exactly how to ensure equal access to credit, with explicit attention to racial disparities, would reinforce existing efforts.”
Economist Barry Eichengreen further enumerates how the European Parliament too can make the ECB Board address credit access to minority and underprivileged groups by collaborating with the national institutions that constitute the European System of Central Banks. By recognising the implications of monetary policy beyond inflation and payments to inequality and climate change, central bankers must use discretion, going ahead, in: (i) using monetary policy to tackle inflation whilst using (ii) other regulatory powers to handle other relevant concerns (such as climate change and inequality) in the mandate.