June 16, 2021
Green Interest Rate Could Help the United States Transition to a Low-Carbon Economy
Central banks and financial regulators are increasingly focused on environmental risks to the financial system and the macro-economy. A new analysis demonstrates how a central bank could operationalize management of environmental pollution and climate risk through monetary policy.
The analysis proposes a green interest rate that transmits information on pollution damages to borrowers and lenders, mitigating damage to the economy by reallocating consumption from periods when output is more pollution-intensive to periods when output is cleaner. These results suggest the important role a green interest rate could play in managing the developing world’s current attempts to transition to a low-carbon economy.
The analysis, by a researcher at Carnegie Mellon University (CMU), appears as a National Bureau of Economic Research working paper.
“This new policy instrument directly addresses concerns articulated by central banks in a recent survey—especially ensuring that a transition to a low-carbon economy occurs in an orderly fashion,” explains Nicholas Muller, Professor of Economics, Engineering, and Public Policy at CMU’s Tepper School of Business, who authored the analysis.
Muller’s proposed green interest rate is a reconceptualization of the natural interest rate that recognizes an expanded role for central banks to include managing environment risks. Two concepts underpinning the natural interest rate prompted him to include pollution damage in his green interest rate—the notion of potential output and the measurement of trend growth in output. In both cases, equations that fail to measure the harm from pollution run the risk of mismeasuring output, which in turn can appreciably shift central banks’ policy rate targets.
By building pollution damage into the interest rate, a green interest rate would compel borrowers and lenders to consider intertemporal changes in pollution intensity of the goods they consume when determining their optimal consumption plans, Muller suggests.
The largest possible impact of targeting the green interest rate would occur when pollution intensity changes rapidly—for example, when binding environmental policy is introduced or during periods of rapid technological intervention, the author suggests. These periods align with risks identified by the Federal Reserve in its 2020 Financial Stability Report.
To operationalize the green rate, Muller estimated air pollution and CO2 damages, then deducted these costs from gross domestic product to estimate environmentally adjusted value added from 1957 to 2016 in the U.S. economy. This 60-year period spans the passage and implementation of landmark federal legislation to control air pollution—including the Clean Air Act of 1970—which significantly altered production processes in power generation, heavy manufacturing, and the light-duty vehicle fleet.
As the present-day economy de-carbonizes, it is these industries that are likely to incur (or already are experiencing) disruptive technological change. Thus, Muller’s analysis can shed light on how using a green rate to set policy targets might affect environmental risks and stability in the coming years.
“For central banks, the onset of climate policy and the associated transition risks to a low-carbon economy carry with them devaluation of and damage to assets,” Muller notes. “Given the political and social obstacles to meaningful climate policy in the near term, examining how a green interest rate would work without environmental regulation is relevant.”
Summarized from an NBER Working Paper, On the Green Interest Rate by Muller, NZ (Carnegie Mellon University). Copyright 2021 by the Author. All rights reserved.