Mission Creep

by | May 10, 2021

“What have central banks ever done for us?” 

“Well, they have kept inflation under control.” “Yes, but apart from inflation, what have central banks ever done for us?” 

“Well, they sorted out the mess from the 2008 financial crisis, and the recession created by the 2020 pandemic.” “Yes, but apart from tackling inflation and financial crises and recessions, what have central banks ever done for us?” 

“They prevented the 21st century climate emergency!”

At this point, we move from a light-hearted dialogue about the role of central banks in a sophisticated modern economy to a more worrying question: Are we asking central banks to do too much? Do they have the tools and mechanisms to perform the myriad of jobs which politicians and societies are asking of them?

During the 1980s and 1990s, the main task facing central banks was to control inflation. In the aftermath of the global financial crisis of 2008-09, central banks took on much greater involvement in regulating the banking system and capital markets, working alongside bodies such as the FCA in the UK and the SEC in the USA. 

Over the past decade, debt management has become a third key task for central banks. True, as long ago as 1977, Congress amended the Federal Reserve Act ‘to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates’ (emphasis added), but matters have rather moved on. Since QE programmes were launched back in 2009, the balance sheets of the seven largest central banks have risen to an astounding $25 trillion, much of that held in government debt instruments making central banks the key actors in the arena of public finance. 

More and more questions have been asked about the impact of such policies on asset prices and wealth inequality, as well as the moral hazard created when QE purchases more than match government debt issuance, and whether it is possible in practice to follow the principle of ‘neutrality’ when selecting corporate bonds in the marketplace.

On top of these targets and objectives there arrives a new mandate – addressing climate change. 

In the recent UK March budget, the Chancellor asked the Bank of England to include risks from climate change in its list of responsibilities. This proposal is quite understandable. After all, climate change is a massive source of financial risk, for instance through stranded assets or catastrophe insurance losses. Going forward, the Bank of England may be responsible for testing the UK financial system’s resilience to physical and transition risks of climate change. It may also have to ensure that the financial system is able to facilitate the necessary finance to support the delivery of the UK’s carbon targets and clean economic growth. 

The UK is far from alone. Other central banks, such as the ECB and Sweden’s Riksbank, have announced their intention to incorporate climate criteria into their QE programmes. Last year, the Federal Reserve joined the Network for Greening the Financial System (NGFS), whose 83 central bank members have identified a range of measures to accelerate the scaling up of green finance. For example, credit operations, collateral decisions and asset purchases could all be tilted one way or another by using negative or positive bond screening. Some commentators have even called for direct monetary action in the form of targeted asset purchases to reduce the cost of capital for green enterprise and environmental innovation.

Mission creep and overload are obvious dangers for central banks. So, too, is the law of unintended consequences. Just as emergency large-scale asset purchases (‘QE’) after the 2008 financial crisis exacerbated income and wealth inequality, spurring on populism, so commitments to new targets could push central banks both further from their original objectives and expose them to fresh unintended consequences (and criticism). That matters because central bank independence is granted by the electorate. It can be withdrawn.

Indeed, a recent NGFS report warned climate change poses new financial risks to central banks’ monetary policy operations. Climate-related financial risks could impact directly on both central bank counterparties and on the financial assets used in monetary policy operations. As a result, climate-related shocks could generate losses for central banks and, in extreme cases, they could affect the smooth implementation of monetary policy by exposing transmission channels to the impacts of physical and transition risks. The report accepted that the frontier is already blurred between the alternative approaches of mitigating central bank balance sheet risk, on the one hand, and actively supporting the transition to low carbon emission technologies on the other. 

To offer examples of these trade-offs, imagine if one of the policy responses to climate change is a carbon tax which brings about higher inflation, will the central bank take counter-vailing action or allow price pressures to ripple through the system? Alternatively, if a central bank directs finance towards certain parts of the economy, other areas will have less access to capital. Job losses could result. An obvious danger with screening companies or government bonds for their green credentials as part of a QE programme is the paucity of data and conflicting signals from rating agencies. How ‘green’ really is a ‘green bond’? In addition, there is already a risk that central bank balance sheets are exposed to climate-related risks from their existing corporate bond portfolios.

Well-intentioned commitments by central banks to stress testing and measurement and evaluation of climate risk disguise the fact that central bankers are being asked to take increasingly active decisions beyond their macro-economic mandates. Already central banks micro-manage financial markets via yield curve control and their perceived support for equity prices. Taking decisions about which issuers to reward, or to punish, on the basis of carbon emissions moves them further away from their long-standing principle of market neutrality. The threat is all the greater given the myriad layers of democratic oversight of central banks that exist in most economies.

Societies place great faith in the ability of central banks to manage an array of risks. Low inflation, plentiful jobs, safe banks, manageable interest rates, stable financial markets, and smooth debt servicing already crowd the agenda, to which is being added the heavy lifting of transitioning to a low carbon economy. Of course, central banks have long juggled trade-offs between economic objectives, for example between jobs and inflation. But in the coming decade those trade-offs look set to grow in new dimensions. Already the Federal Reserve’s ‘Flexible Average Inflation Targeting’ approach injects a significant degree of uncertainty into its future conduct. Central banker guidance about anchored inflation expectations, future interest rate forward guidance or QE tapering needs to be set alongside detailed statements about macro-prudential regulation and now about supporting climate transition. The risk is a blurred cacophony of messages.  

Climate change transition, macro-economic stability and the proper functioning of the financial system are collectively too important to be the co-mingled responsibilities of any one institution. In a world of fiat currency, fractional reserve banking and complex financial products and institutions, the Federal Reserve and other central banks already have enough—perhaps too much—on their plates. 

Climate change must be addressed, but responsibility for tackling it ought to reside with elected officials, and with citizens and businesses via our ethical decisions. Let’s leave central banks to their primary jobs and get on with ours.

About the Author

Andrew Milligan is an independent economist and investment consultant. He is a Board member of the Asia Scotland Institute, an adviser to the Health Foundation, to Balmoral Asset Management and to the Educational Institute of Scotland, and a Fellow of the Society of Professional Economists. From 2000-20, Andrew was the chief market strategist for the global fund manager Aberdeen Standard Investments.

After graduating from Bristol University, Andrew started in H.M. Treasury where he specialised in the IMF and World Bank’s handling of the Latin American debt crisis. He then worked in turn for Lloyds Bank, the broker Smith New Court, and New Japan Securities as an international economist. In 1995 he entered the asset management industry, becoming Head of Economic Research and Business Risk for Aviva Investors. In 2000 he moved to Edinburgh to work as the Head of Global Strategy for Standard Life Investments, in charge of a team covering economic and market research, tactical and strategic asset allocation decisions, client advice and communications for retail and institutional clients globally.

After its merger with Aberdeen Asset Management to form Aberdeen Standard Investments, the company became the second largest active fund manager in Europe with over 30 offices across the major financial centres. Andrew is well known as a public speaker while his writing, commentary and interviews have appeared in all the mainstream media.

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