The effects of climate change on the natural rate of interest: a critical survey

Can climate change shrink central banks' range of motion?

Francesco Paolo Mongelli, Wolfgang Pointner, and Jan Willem van den End study how climate change affects the natural rate of interest in their paper "The effects of climate change on the natural rate of interest: a critical survey".

They review the main channels linking climate change to the natural rate, then simulate outcomes for the euro area using both a central bank model and the DICE climate-economy model out to 2100.

Their main conclusions include:

• In most scenarios the authors review, climate change pushes the natural rate lower, which leaves central banks less leeway to ease policy before they hit the effective lower bound.
• A climate-driven rise in precautionary saving lowers the natural rate by as much as 2.5% in the simulations, far more than physical warming alone.
• Even the most severe pathway, 4.4 degrees Celsius by 2100 with output down nearly 6%, lowers the natural rate by only under 0.3% in the DICE model.
• Disaster risk bites harder in steady-state models: a higher probability of climate-related disasters can cut the long-run natural rate by up to 2.9%, among the largest effects in the survey.
• Lower productivity also feeds through to the natural rate, as output can fall by around 2% for each degree above the human comfort range, and combined physical and transition risk could trim annual trend growth by up to 0.45%.
• Credible carbon pricing, green investment, and active fiscal policy raise investment demand and can lift the natural rate, partly offsetting the downward pressure from climate damages.

This article shows risk aversion is the most powerful channel through which climate change decreases interest rates, way beyond what temperature increases alone would achieve.

These observations add climate alongside demographics, inequality, and productivity to the factors lowering natural rates and central bank's ammunition for the next downturn, but also show an orderly transition can push the rates back up.

The most important caveat is that these model simulations rest on assumptions, not empirical estimates, and the two modelling families disagree sharply: severe warming barely moves the rate in DICE, yet a higher disaster probability cuts it by nearly 2.9% in the steady-state model.