In a 2015 speech, Mark Carney, the then Governor of the Bank of England, sparked a debate over whether monetary policy should look beyond the horizon of the business and credit cycles to ensure financial stability in light of the risks posed by climate change (Carney 2015). Five years later, ECB President Christine Lagarde said that she would move the bank beyond its traditional remit of controlling inflation to include tackling climate change.
Part of the argument for central bank concern about climate change is the risk of financial instability from natural disasters and from the move away from fossil fuels, which would ultimately turn reserves of oil, natural gas, and coal into stranded assets. That transition away from fossil fuels as a source of energy threatens the financial health of corporations, insurers, and other financial corporations that are exposed to fossil fuel assets.
While the overall exposure to fossil fuels in advanced economies such as the UK or EU may appear relatively small, the systemic risk that could result from stranded assets should not be underestimated – after all, the Global Crisis was triggered by developments in the small subprime mortgage market in the US. But for fossil fuel exporters, risks are undeniably large. The high degree of concentration of wealth around fossil fuel assets makes it easy to argue for a monetary policy that looks beyond the business cycle horizon.
Figure 1 Brent oil price (US dollars per barrel)
The collapse in oil prices that started in June 2014 is a stark reminder of the challenges posed by the dependence on oil and other fossil fuels (see Figure 1). Following the discovery of the Covid-19 virus in China at the beginning of 2020 and its subsequent spread, oil prices have further declined on account of reduced oil demand due to social distancing and lockdown measures put in place to stop the virus across the world. In addition, the Covid-19 pandemic might have precipitated oil peak demand – the point at which global crude oil consumption will hit its maximum. Indeed, Covid-19 might durably change behaviour in terms working remotely, hence reducing commuting and the frequency of air travel (see Figure 2).
Figure 2 World crude oil demand
While the literature on appropriate macroeconomic policies for fossil fuel exporters is extensive, much more attention has been paid to the role of fiscal policy. Part of the reason why monetary policy has been relatively overlooked may be because most fossil fuel exporters have pegs or relatively fixed exchange rate regimes (see Figure 3). That is, in the absence of capital controls, they have no independent monetary policy. There are good reasons, however, to take a fresh look at the issue of monetary policy in fossil fuel exporters by broadening the perspective.
Figure 3 Exchange rate regimes in commodity exporters
Traditionally, the monetary policy horizon has been limited to that of the business cycle – typically two to six years. Considering the degree of wealth concentration, the strong complementarity between fiscal and monetary policies, and the emergence of new risks to fossil fuel assets, there is a need to rethink monetary policy in fossil fuel exporters. In a chapter in Arezki et al. (2018), I specifically examine the role monetary policy should play at different horizons – the short term, the medium term and the long term.
A dilemma for fossil fuel exporters is that there are two opposite views of the appropriate response of independent monetary policy to a drop in oil prices. For a central bank pursuing a strict inflation mandate, monetary policy should be tightened if oil prices fall – because a drop in prices would lead to an exchange rate depreciation that would cause prices to rise. But a central bank focused on stabilising output would loosen monetary policy because an oil price drop would lead to lower demand from the oil sector, increasing the output gap of the non-oil economy.
In theory, the new Keynesian framework – with its incorporation of rigidity in wages and goods prices – offers guidance on the correspondence between targeting inflation and targeting output. In a closed economy, the so-called divine coincidence – the equivalence between targeting inflation and output stabilisation – holds under the assumption of limited frictions (Blanchard and Gali 2007). In the context of so-called commodity openness – both consumption and production – there appears to be no divine coincidence under standard assumptions. Flexible inflation targeting is constrained efficient. Some research has also shown that headline rather than core inflation targeting is more appropriate in the presence of credit constraints and when food represents a large share of the consumption basket. Some authors have argued for setting the exchange rate to the domestic currency price of commodity exports. While that rule would stabilise government oil revenue in local currency, it has no clear welfare rationale.
In practice, most countries loosen monetary policy when oil prices fall, suggesting that output stabilisation is more important than targeting inflation.
In the short run then, a peg allows fossil fuel countries to stabilise imported inflation and build credibility if the country maintains fiscal discipline to avoid a pervasive current account deficit. In the case of a currency float, the central bank should set an inflation target. If inflation expectations are anchored, the central bank can afford to also worry about output stabilisation – that is, it can loosen monetary policy in a context of a negative terms-of-trade shock. If inflation expectations are not well-anchored because of limited central bank credibility and if the share of imported goods in the consumption basket is large, a tightening of monetary policy in the face of a negative terms-of-trade shock may be warranted.
Fossil-fuel exporters tend to overspend in good times leading to excessive indebtedness and crisis in bad times. The effectiveness of central banks’ contribution toward stabilisation thus rests on the existence of a credible/sustainable fiscal anchor. The cost of borrowing rises as commodity export prices fall and rises faster when political institutions are weak because of their lack of credibility in providing a fiscal anchor on their own. As a result, there is a need for fiscal and credit rules to limit the amplification of a terms of trade shock. Many countries such as Chile have ended pro-cyclicality by setting up fiscal rules. The differentiated macroeconomic impact of oil shocks on Mexico versus Norway or Chile can be explained by the differences in their degree of fiscal discipline.
Chile is a commodity exporter that has set up a fiscal rule in which an independent council of experts determines overall spending. Then, parliament decides the composition of that spending by picking projects that have been pre-screened by a fiscal authority. The presence of fiscal rules in countries like Norway and Chile that virtually guarantee that the government will not act in ways that amplify the cycle has arguably supported the implementation of monetary policy and specifically inflation targeting. Meanwhile, Mexico lacks the needed constituency to set up and implement a fiscal rule, and settles for a large-scale hedging program against oil price volatility. The difficulty with hedging programmes is the tension that can arise over the perceived cost of the programme during boom times. To allay that concern, the Mexican programme has been designed to capture the uptick from high oil prices using Asian options – where the payoff depends on the average price of the underlying asset over a certain period of time rather than options in which payoff is set by the price at a specific point in time. It should be noted, however, that both fiscal rules and hedging programmes are often politically difficult to put in place and implement.
The lesson in the medium run is that the choice of monetary policy is influenced by the structure of the economy – including the sustainability of fiscal policy, which depends on factors such as depleting reserves, the share of imported goods in aggregate demand, credibility, and political polarisation. Considering the choice of exchange rate regime, fiscal policy can help buffer the shock and smooth the adjustment to a terms-of-trade shock. Macroprudential tools – including capital buffers, risk-based supervision, and time-varying loan-to-deposit and loan-to-value ratios – can also help limit credit and asset price booms and busts and currency mismatches.
To keep the mean global surface temperature from rising less than 2°C, only 300 to 400 gigatonnes of carbon can still be emitted into the atmosphere. But fossil fuel reserves of major private oil and gas producers contain three times that much carbon. To abide by international commitments to limit global warming, a third of oil, half of gas, and 80% of coal reserves should be kept in the ground forever (McGlade and Ekins 2015). This would mean that a third of the oil reserves in Canada and the Arctic, 50% of gas and 80% of coal (mainly in China, Russia, and the US) cannot be extracted. In the Middle East, reserves are three times larger than should be extracted under climate commitments. In other words, 260 billion barrels of oil in Middle East cannot be burned. In addition to these stranded reserves, the structures and capital used in extraction and in exploitation of fossil fuel can become stranded as well.
Many fossil fuel exporters have been concerned with the need to diversify their economies. Very few, however, have successfully moved away from their dependence on fossil fuels. The regulatory and technological changes sweeping the energy market may make such a transition more urgent. To help structural policies, central banks in fossil fuel countries ought to work on the longer end of the yield curve to facilitate longer-term investment and diversification. The response to the risk of stranded assets may have a bearing on the asset allocation of fossil fuel exporters. Many oil exporters have accumulated vast financial assets and the strategic asset allocation of the latter is all the more important considering the new risks to their main source of wealth. By looking beyond the business cycle horizon, central banks have a critical role to help investments in financial assets that are not based on fossil fuel.
The risk of stranded reserves and capital is much bigger for fossil fuel exporters than for advanced economies. Monetary policy needs to reflect and communicate on such existential threats and advocate that appropriate structural policies are adopted to diversify the economy with an appropriate interest rate policy. It must also provide supportive financial policies to help the diversification and also adapt the strategic asset allocation including of sovereign wealth funds.
Arezki, R, R Bouccekine, J Frankel, M Laksaci and F van der Ploeg (2018), Rethinking the Macroeconomics of Resource Rich Countries, aVoxEU.org eBook, London: CEPR Press.
Blanchard, O and J Galí (2007). "Real Wage Rigidities and the New Keynesian Model", Journal of Money, Credit and Banking 39(1): 35-65.
Carney, M (2015), “Breaking the tragedy of the horizon - climate change and financial stability”, Speech given at Lloyd's of London.
Ilzetzki, E, C M Reinhart and K S Rogoff (2019), "Exchange Arrangements Entering the Twenty-First Century: Which Anchor will Hold?", The Quarterly Journal of Economics 134(2): 599-646.
McGlade, C and P Ekins (2015), “The geographical distribution of fossil fuels unused when limiting global warming to 2 °C”, Nature 517 (7533): 187-190.