By Benjamin Carton and Jean-Marc Natal The world must cut greenhouse gas emissions by at least a quarter before the end of this decade to achieve carbon neutrality by 2050. Progress needed toward such a major shift will inevitably impose short-term economic costs, though these are dwarfed by the innumerable long-term benefits of slowing climate change. In our latest World Economic Outlook, we estimate the near-term impact of different climate mitigation policies on output and inflation. If the right measures are implemented immediately and phased in over the next eight years, the costs will be small. However, if the transition to renewables is delayed, the costs will be much greater. To assess the short-term impact of transitioning to renewables, we developed a model that splits countries into four regions—China, the euro area, the United States, and a block representing the rest of the world. We assume that each region introduces budget-neutral policies that include greenhouse gas taxes, which are increased gradually to achieve a 25 percent reduction in emissions by 2030, combined with transfers to households, subsidies to low-emitting technologies, and labor tax cuts. The results show that such a policy package could slow global economic growth by 0.15 percentage point to 0.25 percentage point annually from now until 2030, depending on how quickly regions can wean off fossil fuels for electricity generation. The more difficult the transition to clean electricity, the greater the greenhouse gas tax increase or equivalent regulations needed to incentivize change—and the larger the macroeconomic costs in terms of lost output and higher inflation. For Europe, the United States, and China, the costs will likely be lower, ranging between 0.05 percentage point and 0.20 percentage point on average over eight years. Not surprisingly, the costs will be highest for fossil-fuel exporters and energy-intensive emerging market economies, which on balance drive the results for the rest of the world. That means countries must cooperate more on finance and technology needed to reduce costs—and share more of the required know-how—especially when it comes to low-income countries. In all cases, however, policymakers should consider potential long-term output losses from unchecked climate change, which could be orders of magnitude larger according to some estimates. In most regions, inflation increases moderately, from 0.1 percentage point to 0.4 percentage point.  To curb the costs, climate policies must be gradual. But to be most effective, they also need to be credible. If climate policies are only partially credible, firms and households will not consider future tax increases when planning investment decisions. This will slow the transition (less investment in thermal insulation and heating, low-emitting technologies, etc.), requiring more stringent policies to reach the same decarbonization goal. Inflation would be higher and gross domestic product growth lower by the end of the decade as a result. We estimate that only partially credible policies could almost double the cost of transitioning to renewables by 2030. Inflation and monetary policy A pressing concern among policymakers is whether climate policy could complicate the job of central banks, and potentially stoke wage-price spirals in the current high-inflation environment. Our analysis shows this is not the case. Gradual and credibly implemented climate mitigation policies give households and firms the motive and time to transition toward a low-emission economy. Monetary policy will need to adjust to ensure inflation expectations remain anchored, but for the kind of policies simulated, the costs are small and much easier for central banks to handle than typical supply shocks that cause a sudden surge in energy prices. Using the United States as an example, we show how climate policies impact inflation and growth under a range of scenarios. When policies are gradual and credible, the output-inflation trade-off is small. Central banks can choose to either stabilize a price index that includes greenhouse gas taxes or let the tax fully pass through prices. The former would only cost an additional 0.1 percentage point of growth annually. If the transition is more difficult—reflecting a slower transition to clean electricity generation—the trade-off increases but remains manageable. The costs would be much higher if monetary policy were to lose credibility, a concern in today’s high-inflation environment. If inflation expectations become de-anchored, introducing climate policies could lead to second-round effects and a larger output-inflation trade-off, as illustrated by the less-credible monetary policy scenario. Our analytical chapter shows how to design climate policies to avoid such a situation, curbing the impact of the greenhouse gas tax on inflation with subsidies, feebates or labor tax cuts.  Is it reasonable to wait—as some have proposed—until inflation is down before implementing climate mitigation policies? We ran a scenario delaying implementation until 2027 that still achieves the same reduction in cumulative emissions in the long term. The delayed package is phased in more rapidly and requires a higher greenhouse gas tax, since a steeper decline in emissions is necessary to offset the accumulation of emissions from 2023 to 2026. The results are striking. Even in the most favorable circumstances when monetary policy is credible and the transition to decarbonized electricity is rapid, the output-inflation trade-off would rise significantly; GDP would have to drop by 1.5 percent below baseline over four years to drive inflation back to target. Delay beyond 2027 would require an even more rushed transition in which inflation can be contained only at significant cost to real GDP. The longer we wait, the worse the trade-off.  Better understanding the near-term macroeconomic implications of climate policies and their interaction with other policies is crucial to enhance their design. Transitioning to a cleaner economy entails short-term costs, but delaying will be far costlier. —This blog is based on Chapter 3 of the October 2022 World Economic Outlook, “Near-term Macroeconomic Impact of Decarbonization Policies.” The authors of the chapter are Mehdi Benatiya Andaloussi, Benjamin Carton (co-lead), Christopher Evans, Florence Jaumotte, Dirk Muir, Jean-Marc Natal (co-lead), Augustus J. Panton, and Simon Voigts. (Photo: Drazen_/iStock by Getty Images) | By John Bluedorn Inflation in some economies is rising at the fastest pace in four decades, while tight labor markets have boosted pay gains. That has raised concerns that these conditions could become self-reinforcing and lead to a wage-price spiral—a prolonged loop in which inflation leads to higher wage growth, fueling even higher inflation. An examination of recent wage dynamics and the prospect of such a wage-price spiral are the subjects of an analytical chapter of our latest World Economic Outlook, which finds that, on average, the risks of a spiral are limited—so far. Three factors are working together to contain the risks: the underlying shocks to inflation are coming from outside the labor market, falling real wages are helping to reduce price pressures, and central banks are aggressively tightening monetary policy. A look at history To better understand these dynamics, we identified 22 situations in advanced economies over the past 50 years with conditions similar to 2021 when price inflation was rising, wage growth was positive, but real wages and the unemployment rate were flat or falling. These episodes didn’t lead to wage-price spirals on average.  Instead, inflation came down in subsequent quarters and nominal wages gradually rose, helping real wages recover. Although the shocks hitting economies are unusual, these findings provide some reassurance that sustained wage-price spirals are rare. But that should not be cause for complacency by policymakers—there are differences across episodes, with some showing worse outcomes. Inflation in the United States, for example, kept rising and real wages fell for a while after 1979, when the economy was hit by further oil price hikes. The inflation trajectory changed only when the Federal Reserve raised interest rates sharply. The role of expectations How expectations are formed matters a lot for wage and price dynamics and affects what actions policymakers should take after an inflationary shock. Inflation expectations became more important in explaining wage dynamics over the second half of 2021, according to an empirical analysis. To study how expectations affect the economy, we used a model-based analysis, calibrated to reflect economic conditions in the first half of this year and taking the policy rate path as given. When businesses and households expect future inflation to be the same as it is today, an inflationary shock can lead workers to demand even more to compensate for perceived higher future inflation. This kind of backward-looking expectations process—what we refer to as fully adaptive—can lead inflation to rise and stay above the central bank’s inflation target for a prolonged period even if there are no additional price shocks. By contrast, when people’s expectations reflect all available economic information—referred to as rational—businesses and households see the shock to wages and prices as temporary, leading wage growth and inflation to quickly move back towards target and stay anchored.  In most places, the reality lies somewhere between these extremes, with businesses and households looking at what happened in the past (weighing recent quarters more heavily) to learn about the economy’s structure and make predictions, referred to as adaptive learning. In this case, wage growth and inflation can take longer to come back to the central bank’s target than when expectations are rational, but faster than when they are fully adaptive. In all these cases, real wages tend to go down initially as inflation outstrips wage growth, helping offset some of the cost-push shock that fueled inflation and working against a wage-price spiral. But if inflationary shocks start to come from the labor market itself—such as an unexpected, sharp uptick in wage indexation—that could moderate the effects of falling real wages, pushing up both wage growth and inflation for longer. For monetary policymakers, understanding the expectations process is critical. When expectations are more backward-looking, monetary policy tightening—including through clear communications by the central bank—should be stronger and more front-loaded in response to an inflation shock. In that sense, recent tightening actions by many central banks—calibrated to economy-specific circumstances—are encouraging. They will help to prevent high inflation from becoming entrenched and inflation from deviating from target for too long. — This blog is based on Chapter 2 of the October 2022 World Economic Outlook, “Wage Dynamics Post-COVID-19 and Wage-Price Spiral Risks.” The authors of the report are Silvia Albrizio, Jorge Alvarez, Alexandre Balduino Sollaci, John Bluedorn (lead), Allan Dizioli, Niels-Jakob Hansen, and Philippe Wingender, with support from Youyou Huang and Evgenia Pugacheva. (Photo: MicroStockHub/iStock by Getty Images) | By Fabio Natalucci, Mahvash S. Qureshi, and Felix Suntheim Mutual funds that allow investors to buy or sell their shares daily are an important component of the financial system, offering investment opportunities to investors and providing financing to companies and governments. Open-end investment funds, as they are known, have grown significantly in the past two decades, with $41 trillion in assets globally this year. That represents about one-fifth of the nonbank financial sector’s holdings. These funds may invest in relatively liquid assets such as stocks and government bonds, or in less-frequently-traded securities like corporate bonds. Those with less-liquid holdings, however, have a major potential vulnerability. Investors can sell shares daily at a price set at the end of each trading session, but it may take fund managers several days to sell assets to meet these redemptions, especially when financial markets are volatile. Such liquidity mismatch can be a big problem for fund managers during periods of outflows because the price paid to investors may not fully reflect all trading costs associated with the assets they sold. Instead, the remaining investors bear those costs, creating an incentive for redeeming shares before others do, which may lead to outflow pressures if market sentiment dims. Pressures from these investor runs could force funds to sell assets quickly, which would further depress valuations. That in turn would amplify the impact of the initial shock and potentially undermine the stability of the financial system. Illiquidity and volatility That’s likely the dynamic we saw at play during the market turmoil at the start of the pandemic, as we write in an analytical chapter of the Global Financial Stability Report. Open-end funds were forced to sell assets amid outflows of about 5 percent of their total net asset value, which topped global financial crisis redemptions a decade and a half earlier. Consequently, assets such as corporate bonds that were held by open-end funds with less-liquid assets in their portfolios fell more sharply in value than those held by liquid funds. Such dislocations posed a serious risk to financial stability, which were addressed only after central banks intervened by purchasing corporate bonds and taking other actions.  Looking beyond the pandemic-induced market turmoil, our analysis shows that the returns of assets held by relatively illiquid funds are generally more volatile than comparable holdings that are less exposed to these funds—especially in periods of market stress. For example, if liquidity dries up the way it did in March 2020, the volatility of bonds held by these funds could increase by 20 percent. This is also of concern to emerging market economies. A decline in the liquidity of funds domiciled in advanced economies can have significant cross-border spillover effects and increase the return volatility of emerging market corporate bonds. Now the resilience of the open-end fund sector may again be tested, this time amid rising interest rates and high economic uncertainty. Outflows from open-end bond funds have increased in recent months, and a sudden, adverse shock like a disorderly tightening of financial conditions could trigger further outflows and amplify stress in asset markets.  As IMF Managing Director Kristalina Georgieva said in a speech last year, “policymakers worked together to make banks safer after the global financial crisis—now we must do the same for investment funds.” How should those risks be curbed? As we write in the chapter, asset volatility induced by open-end funds can be reduced if funds pass on transaction costs to redeeming investors. For example, a practice known as swing pricing allows funds to adjust their end-of-day price downward when facing outflows. This reduces the incentive for investors to redeem before others. Doing so eases outflow pressures faced by funds in times of stress, and the likelihood of forced asset sales. But while swing pricing—and similar tools such as antidilution levies, which pass on transaction costs to redeeming investors by charging a fee—can help mitigate financial stability risks, they must be appropriately calibrated to do so, and that’s not the case right now. The adjustments that funds can make to the end-of-day prices—known as swing factors—are often capped at insufficient levels, especially in times of market stress. Policymakers therefore need to provide guidance on how to calibrate these tools and monitor their implementation.  For funds holding very illiquid assets, such as real estate, calibrating swing-pricing or similar tools may be difficult even in normal times. In these cases, alternative policies should be considered, like limiting the frequency of investor redemptions. Such policies may also be suitable for funds based in jurisdictions where swing pricing cannot be implemented for operational reasons. Policymakers should also consider tighter monitoring of liquidity management practices by supervisors and requiring additional disclosures by open-end funds to better assess vulnerabilities. Furthermore, encouraging more trading through central clearinghouses and making bond trades more transparent could help boost liquidity. These actions would reduce risks from liquidity mismatches in open-end funds and make markets more robust in times of stress. |
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