Rate cuts stabilize output during carbon price shocks, model shows
Central banks should lower policy rates to cushion output contractions when carbon prices rise, according to a Bank of England working paper published in October 2026. The authors find that optimal monetary policy prioritizes real output over short-term inflation stabilization.
Shielding output over headline prices
The multi-sector Environmental New-Keynesian model developed by Marco Carli, Francesca Diluiso, and Mathias Hoffmann reveals that climate policy shocks confront central banks with distinct trade-offs.
Calibrating an upstream carbon price shock to generate a 5 percent reduction in emissions within the first year, the simulations show that higher fossil fuel prices drive up energy costs and headline inflation while contracting output.
Rather than tightening, the social planner lowers the policy rate to cushion real activity, household consumption, and employment.
Conversely, green subsidy shocks generate an economic expansion alongside falling inflation, prompting optimal policy to lift rates to contain volatility.
The breakdown of divine coincidence
This mechanism hinges on imperfect substitutability between green and fossil energy, as well as complementarities between energy and labor.
Unlike Cobb-Douglas specifications with fixed cost shares, variable cost shares cause the divine coincidence to break down: stabilizing marginal costs requires large declines in wages and employment.
Wage stickiness deepens this distortion.
Combining carbon pricing with green subsidies sterilizes relative price swings, capping energy price rises at 0.5 percent and removing the policy trade-off.
Easier modeled than executed
Prescribing rate cuts during an inflation spike delivers a sharp challenge to orthodox monetary policy.
In reality, central bankers risk unanchoring expectations by easing rates while consumer energy bills surge.
Theory clarifies these supply trade-offs, but coordinated fiscal recycling remains the only viable stabilizer.