In late 2021, consumer price inflation surged in many countries. Prices shot up again following Russia’s invasion of Ukraine in February 2022. In response, central banks drastically tightened monetary policy – raising interest rates from near zero to around 5% or more. Since the interest rate hikes have failed to bring down core inflation to the target rate of 2% favored by the Federal Reserve and the European Central Bank (ECB), the pressure for further rate hikes has been insistent.
We have long doubted that central bank rate rises could control the new inflation at a socially acceptable price. In most countries, wages lag well behind inflation. Too much of the rise in prices clearly reflects the impact of higher profit margins and obvious supply bottlenecks.
In such conditions, leaving control of inflation to central banks is like asking an old-time central bank to fix a harvest failure. Only targeted policies to increase output and control profit margins in strategic sectors, not general increases in the price of borrowed money, have much chance of working.
But relying on central bank rate rises in the current situation is folly for another reason: the reality of the climate crisis, which now greatly complicates the task of central banks and policymakers. One reason is obvious: higher interest rates considerably slow down the renewable energy transition. This happens in two ways.
First, newly applied renewable energy technologies, which have relatively large front-loaded costs, are more competitive (relative to the already installed fossil fuel technologies) only when interest rates are low.
Engineering studies show that the levelized cost of electricity (LCOE) of solar photovoltaics (PV) and wind onshore will increase by 11% and 25%, respectively, if interest rates are 4-4.5% (rather than around zero). Investments in new renewable energy capacity are thus only viable if market prices allow them to earn their full LCOE.
Estimates by the International Energy Agency suggest that the LCOE of a gas-fired power plant would increase by about 4% if interest rates were to increase from 3% to 7%, whereas that of offshore wind and solar PV (utility scale) could rise by more than 30%.
Second, high interest rates shield legacy oil and gas producers from the competition of up-and-coming low-carbon energy producers. They will enable oil and gas giants to continue to maximize revenues from their decaying, sun-setting assets; oil in particular can keep charging more and more for less and less for a long time.
The year 2022 already gave us a flavor of the shape of things to come: Exxon posted $56bn in net profits for the year, while all oil majors combined made close to net $200bn. These windfall profits are very good news for shareholders, as Exxon is planning to spend $30bn on share repurchases in 2023 and another $50bn in 2024.
But they are bad news for the rest of us – as high interest rates de-incentivize investments in renewables, lock our economies more deeply into fossil-fuel dependence, slow down decarbonization and put us even more strongly on the road to hothouse Earth.
Paradoxically, as a result of all this, monetary tightening is also guaranteed to make it harder for the Fed or the ECB to achieve their goal of price stability. After all, global heating, if unstopped, increases the frequency of natural disasters (flooding and wildfires) and extreme weather events (droughts). We have all seen in the last few years how these disrupt global food supplies, upset global commodity chains and further destabilize the already unstable financial system. Right now, blazing heat in Spain and parts of Asia is disrupting agriculture and putting pressure on already strained ecosystems and supply chains.
But worsening supply bottlenecks that stoke inflation is only part of the price ordinary citizens pay from climate crisis. They also have to cope with all kinds of new or growing risks. For example, in response to the heightened flooding risks, insurance firms are leaving Florida, and larger insurers are cancelling policies among homeowners in the region.
Similarly, more than 340,000 Californian homeowners lost private property insurance coverage due to wildfires that are increasing in frequency and intensity and had to turn to an expensive state-backed insurance program.
Contrary to the wrong-headed consensus among macroeconomists and central bankers, monetary tightening is incapable of lowering current, and future climate crisis-induced, inflation.
US inflation has recently surged due heavily to supply-side causes, including higher import and energy prices, sharp rises in corporate profit margins, and the far-reaching (and continuing) negative impacts of Covid on mostly low-wage labor markets. At the same time, aggregate demand did increase, thanks to unprecedented gains in household wealth during 2020-22, particularly for the richest 10% of US households.
Going forward, climate crisis and the general drift to a belligerently multipolar world system are likely to further stress global supply chains, leading to shortfalls in supply – and therefore inflation – as firms shift supply chains around to geopolitically more secure sites.
This type of inflation responds to monetary tightening and higher unemployment only at prohibitively high social cost. It requires instead targeted solutions, including (strategic) price controls, new regulations to curb commodity market speculation, and industrial policy and public spending to accelerate the green transition.
When supply becomes more variable, fiscal policy also has to adapt: existing explorations of ways to steady demand have to embrace much bolder macroeconomic measures to control over-spending when supply is temporarily constrained. These measures should include taxing windfall profits (of the oil majors and other oligopolists), prioritizing public investment and bank credit for renewable energy generation and decarbonization, antitrust and effective control of overspending by the rich.
This does not mean prohibitively high rates of taxation, though we think taxes need to rise on higher incomes and offshore tax havens need to be sealed. Rather, John Maynard Keynes’ suggestion to control wartime inflation by requiring wealthier citizens to save some of their income by investing in interest-paying bonds is a much more humane way of limiting spending than throwing people out of work.
Monetary policy has to support such fiscal policy initiatives, rather than obstruct governments by raising interest rates and choking off the multiplier effects of public spending and financing the climate transition.
Our thinking about monetary policy has to change. Instead of treating central bankers as powerful, benevolent, technocratic guardians of price and macro stability, it is time to downgrade their role to that of servants of fiscal and industrial policies. These need to be geared toward promoting rapid decarbonization and the renewable energy transition. Only by doing this will we be able to avoid climate change-induced disruptions and achieve greater price stability.
If central bankers are unwilling to learn to play second fiddle, they’ll end up fiddling while our world burns.
Thomas Ferguson is professor emeritus at the University of Massachusetts, Boston, and director of research at the Institute for New Economic Thinking
Servaas Storm is a senior lecturer at the Delft University of Technology