The Bank of England published a staff working paper examining how monetary policy should respond to carbon pricing and green subsidy shocks. Using an Environmental New Keynesian model with green and fossil energy, the authors find that these shocks create a trade-off between inflation and output stabilization. The model’s optimal policy prioritizes limiting real output fluctuations while temporarily looking through inflation movements and preserving medium-term price stability. The appropriate interest rate response depends on the climate policy. A carbon price increase is inflationary and contractionary, but the model prescribes a lower policy rate to support consumption, employment and output. A green subsidy is deflationary and expansionary, yet the optimal response is a higher rate to curb excessive economic volatility, including increased labor demand in the green energy sector. Dual mandate Taylor rules that respond to both inflation and the output gap produce lower welfare costs than inflation-only rules. Core inflation targeting generally performs better than headline inflation targeting, although the welfare gap narrows when energy complementarities are incorporated and largely disappears under dual mandate rules.
Bank of England research finds monetary policy should prioritize output stabilization after climate policy shocks
Bank of England staff research finds that monetary policy should prioritize output stabilization when carbon pricing or green subsidies create inflation-output trade-offs. The model prescribes a rate cut after an inflationary, contractionary carbon price shock and a rate increase after a deflationary, expansionary green subsidy shock. Dual mandate Taylor rules produce lower welfare costs than inflation-only approaches.