Climate Policies and Monetary Policies in the Euro Area

This paper presents two types of analysis on the interaction between policies to deal with climate change and monetary policies in the euro area. First, we empirically analyse the historical effects of carbon taxes on inflation in the euro area countries to gauge the impact under the current European monetary regime. Second, we explore two alternative monetary policy rules under a range of simulations in a new European version of the G-Cubed multisector model. We study the economic and inflationary impacts of physical climate change shocks (climate risk) and transitions risks arising from carbon taxation within Europe and globally. We find that under the existing monetary policy framework, the inflationary effects of carbon taxes in Euro area countries have been contained. The only significant increase in the HICP (of about 0.8 index points) is found in the first two years, while the impact on core inflation tended to be negative. Thus, carbon taxes mainly affected relative prices rather than the overall price level, which is in line with previous findings for a broader sample of countries. We also find that producers seem to have absorbed a part of the carbon tax since consumer price inflation was lower than producer price inflation. The results from the simulation model show that the nature of the monetary rule within Europe has a significant effect on the impact of climate shocks and carbon taxation. An entirely forward-looking rule proposed by Hartmann and Smets (2018) may lead to excessively tight monetary policy in the face of climate shocks and climate policy changes within Europe. An alternate modified version of this rule that puts equal weights on current and forward-looking variables leads to a better short-run outcome for Europe. We also find a difference in results for Europe between the impact of climate policy implemented only within the Euro area and climate policy implemented globally. The main difference is the impact of global policies versus Euro area policies on international capital flows and the exchange rate. Overall, the model simulations suggest that physical climate risk as well as transitions risks from carbon pricing have long run output costs but only a transitory impact on inflation. Moreover, the price reaction critically depends on the monetary policy regime, which may result either in inflation or deflation in the short run.