Greener Energy Push will drive Inflation Higher

Probably the most debated topic in Economics right now is the surging inflation rate. Economists across the globe are discussing its causes, its character, whether it is transitory or  here to stay, and the best policies to tamp it down.

In the last weeks we have seen how Central Banks across the world have started to implement different policies to tackle this surge in inflation rate.

In the US, during a confirmation hearing for his second term as Federal Reserve chairman Jerome Powell said that the current inflationary rally is caused by Covid 19 financial “stimuli” to households and by the supply bottlenecks, mentioning the car and the energy sectors as the most problematic ones. Moreover, he affirmed that the Fed will start implementing measures to cool it down, eventually reducing expansionary open market operations.

On the other side of the Atlantic, Bank of England’s Chief Economist Huw Pill, interviewed by CNBC, explained how the BoE is set to dismantle some of the policies implemented to sustain the economy,  withdrawing  “some of the extraordinary monetary accommodations”, as they now appear to be major drivers for inflation, together with a labor market tighter than expected.

The European Central Bank so far took a diverging policy path, with the President Christine Lagarde claiming that interest rate increases in 2022 are very unlikely, because “the Eurozone economies are at a different phase of the economic cycle and received different levels of government support during the pandemic”.

Nevertheless, the consumer price index in the eurozone has reached 5.0% in December, driven for the most part by surging energy and gas prices.

Referring to this major issue, an interesting contribution to the debate came from Isabel Schnabel, Member of the Executive board of the European Central Bank at a panel on “Climate and the Financial System” at the American Finance Association 2022 virtual annual Meeting.

In that occasion the German economist, professor at Bonn University, highlighted how in 2021 the global economy was shaken by a major energy crisis, and still to favor the fight against climate change prices of fossil fuels have to keep increasing. It will be the role of the ECB to assess whether the green transition poses risks to price stability and to which extent deviations from their inflation target are tolerable.

The ECB board member continues describing the two main developments that are reinforcing the effects of higher carbon prices, the European Commission’s Fit for 55 package and a fundamental reshaping of financial markets.

The former includes a review of the EU Energy Taxation Directive, with the aim of raising the minimum tax rate for inefficient and polluting fuels while lowering those for efficient and clean ones, whereas the latter is the ongoing transition to sustainable investments, an essential ingredient in most investors’ portfolios, coming at the expense of fossil fuel energy producers.

This is another proof of how the financial markets can act as a corrective device, as right now there is positive relationship between greenhouse gas emissions resulting from a firm’s operations and credit risk estimates, that in turn reduce the willingness to hold this firm’s securities.  

Still the transition may come to a cost for businesses and households, because it is not yet possible to fully substitute more expensive carbon intensive energy with greener and cheaper alternatives, as they have not proved to be scalable enough to meet rising demand.

All of these effects result in a phase in which energy bill will be rising: energy price inflation in the euro area reached a historical high in November, with electricity and gas jointly accounting for more than a third of the total increase. The surge in has been boosted also by the uncertainty of the Russian-Ukrainian crisis.

In conclusion, the overall scenario calls for an active intervention by governments and central banks. On the fiscal side many governments have responded to rising energy prices by imposing tax cuts and price caps to help less well-off households, while maintain the commitment to decrease greenhouse emissions, necessary to reach the goals of the Paris Agreements.

On the monetary side, Schnabel realizes the difficulty of the central bank in intervening in such situations because of the nature of energy price shocks, generally strong but short lived, and that of policy interventions, the results of which suffer from long time lags. Yet an intervention may be needed if inflation expectations have become deanchored.