In 2024, the Global Footprint Network estimated “humans use as much ecological resources as if we lived on 1.7 Earths.” This overuse of resources highlights how the global economy has developed at the cost of continuous environmental degradation. The 2021 Dasgupta Review—a comprehensive report on the economics of biodiversity—estimated that, between 1992 and 2014, human capital per person, defined as labor, skills, and knowledge, increased by around 13% and produced capital per person such as roads, buildings, and factories doubled. Meanwhile, natural capital per person, defined as “the stock of renewable and non-renewable natural assets that yield a flow of benefits to people,” fell by 40%.

As we grapple with challenges arising from climate change and loss of biodiversity, there is a growing need to incorporate environmental considerations in economic decisionmaking.

Environmental degradation arises from what economists refer to as the externality problem: The failure of individuals directly involved in a transaction to account for the indirect costs borne by society. An example of this would be a landowner cutting down a forest without considering its role in absorbing greenhouse gasses. In addition, quantifying the value of clean air or unpolluted rivers using traditional economic metrics is challenging in the absence of a formal market. As a result, humanity has treated the services provided by nature (“ecosystem services”)—such as oxygen from trees, pollination of crops by bees, and mitigation of flooding from wetlands— largely as if they were free, without considering the depletion of these resources caused by their actions.

Addressing externalities involves incorporating societal costs into the price of goods and services created in the economy. Ideally, we would estimate and price the carbon emitted during production, the loss of biodiversity caused by water pollution, the depletion of oxygen from deforestation, and so forth. The underlying idea is to value forests, lakes, and other natural resources not only for the goods they can be turned into but also for the value they provide to society when they remain in their original natural form. For instance, plants absorb the CO2 in the atmosphere and release oxygen through photosynthesis. So, in principle, it is possible to calculate the price of CO2 emissions by estimating the cost of planting trees to offset them. However, valuing other environmental externalities is more complex. Assigning a monetary value to biodiversity loss—such as the extinction of animal species due to climate change—is particularly challenging because it involves factors that are not easily quantifiable, like the intrinsic value of different animal species and the long-term impacts on ecosystems.

Despite the difficulties in assigning a monetary value to environmental externalities and ecosystem services, financial markets could offer tools and mechanisms to address these challenges by accounting for businesses’ environmental impact and channeling investments toward sustainable initiatives. By developing financial instruments that recognize the value of natural resources, we could incentivize companies to prioritize the preservation of the environment. This approach could help quantify the value of nature and direct funds towards ventures with positive environmental impact. In the following sections, we examine how financial markets are attempting to incorporate the value of nature and assess the effectiveness of these efforts.

Sustainable investments aim to generate financial returns while promoting environmental or social value. Often labeled “ESG”—which refers to environmental, social, and governance—these investments encompass a wide variety of instruments. These range from green bonds—debt securities issued to finance projects with positive environmental impacts—to ESG-focused exchange-traded funds (ETFs) that select stocks or bonds based on ESG criteria.

Despite recent backlash, demand for ESG investments has increased in recent years and is expected to continue growing in the U.S. A recent study shows that, in the year following the publication of sustainability ratings by a well-known rating agency in 2016, “high-sustainability” funds experienced $24 billion in net inflows while “low-sustainability” funds instead experienced $12 billion in net outflows. This occurred despite a lack of evidence that high-sustainability funds outperform low-sustainability funds.

Yet significant concerns remain regarding the effectiveness and transparency of ESG labels. An analysis of self-labeled ESG mutual funds in the U.S. has found that these funds held a portfolio of firms with “worse track records for compliance with labor and environmental laws” compared to those held by non-ESG funds within the same financial institutions between 2010 and 2018. The authors found that, despite the ESG funds holding portfolios of firms with higher ESG scores, these scores were correlated with the quantity of voluntary ESG-related disclosures rather than actual compliance records or levels of carbon emissions.

Another study that analyzed emissions data from over 3,000 companies between 2002 and 2020 suggests that sustainable investment strategies involving divestment from “brown” firms in favor of “green” ones may be counterproductive. The authors found that when “green” firms experience a lower cost of capital, their emissions do not change much, but when “brown” firms experience a higher cost of capital, their emissions increase significantly. This is because divesting from “brown” firms increases their cost of capital and forces them to continue using their current high-pollution production methods rather than investing in new green technologies that could reduce emissions.

Finally, an analysis of biodiversity finance deals from 2020 to 2022 found that approximately 60% were financed solely by private capital, while the remaining 40% involved “blended finance”—private capital combined with public or philanthropic funding. The study also revealed that pure private capital tended to finance smaller-scale deals with higher expected financial returns but less ambitious biodiversity impacts. In contrast, blended finance was used for larger-scale projects with lower profitability but more ambitious biodiversity impacts. The authors suggest that blended finance is a useful tool for attracting private investors by reducing their risk and bridging the profitability gap.

Environmental credits are financial instruments that allow purchasers to support specific environmental actions indirectly. For example, by buying carbon credits, an investor pays another company to reduce its greenhouse gas (GHG) emissions. Compared to other types of emerging credits, the carbon credit market is well-established: In 2022, the voluntary carbon market had a market size of around $2 billion covering 1.7 gigatons of carbon, and the compliance markets had a market size of around $850 billion covering just under 20% of global GHG emissions in 2021.

Other types of nature-related credits, such as biodiversity credits, have been proposed to create financial rewards for conservation. Under this model, a company devises a plan for improving biodiversity and implements it with regular monitoring, either by the company itself or a third party. A biodiversity credit is generated when the monitoring confirms that specific biodiversity goals have been met. The credit can then be sold, with the revenue shared between the landowner and the biodiversity credit developer. A few companies have begun selling biodiversity credits, and the United Nations is currently facilitating a voluntary international alliance on biodiversity credits. The EU is also exploring biodiversity credits and biodiversity-linked carbon credits through its Climate Biodiversity Nexus project.

Challenges facing these nature-based credits include ensuring that the revenues from the credits are used towards their intended goals and accurately measuring the environmental impact.

Another approach to internalizing environmental externalities in financial markets is the creation of nature-preserving companies. These companies’ primary purpose is to purchase or lease land and manage it to generate ecosystem services. Landowners may donate or sell conservation easements, which results in the landowner forfeiting certain rights, such as the right to develop or subdivide the land. There are 221,256 conservation easements covering approximately 38 million acres of land in the U.S. While conservation easements are associated with tax benefits for landowners, the Internal Revenue Service has observed abuses of these tax advantages.

In some cases, these companies are envisioned to be publicly traded and listed on exchanges, with the idea that the price-discovery process associated with trading would reflect the value of protecting natural assets. This model was being considered by the Securities and Exchange Commission when the New York Stock Exchange proposed listing “natural asset companies” to be publicly traded. While the proposal was withdrawn in January 2024, the New York Times notes that there are prototypes of this model underway in private markets.

Nature-preserving companies aim to generate economic returns alongside their conservation efforts. These returns are typically achieved through the sale of carbon credits or economic activities such as sustainable agriculture, property rental, renewable energy production, and ecotourism. Proceeds from these activities may be applied to repay loans used to purchase the land.

Integrating the value of nature into nature-preserving companies is challenging for several reasons. First, basic finance valuation formulas imply that a company’s stock price is the discounted value of all the future cash flows investors expect it to generate. In competitive markets, nature-based companies would need to offer competitive returns to their investors to secure the financing they need to operate successfully. However, to generate such profits, companies may be forced to monetize the ecosystem services or extract values from the natural resources they oversee rather than preserve them. If this extraction of value is necessary to attract investors, economic activities should be conducted in a sustainable, transparent way—for example, through sustainable agriculture or ecotourism.

Another challenge relates to ensuring transparency and rigorous oversight of the activities of nature-preserving companies. These companies must demonstrate that their operations genuinely benefit the environment, but measuring biodiversity, for example, is inherently difficult due to its complex nature. Implementing the auditing and reporting frameworks necessary to monitor these activities is also a complex task, often requiring significant resources and expertise. The lack of standardized metrics for biodiversity further hampers investors’ ability to evaluate the true impact of their investments.

Despite these challenges, nature-preserving companies embody the powerful idea that assigning value to nature’s intrinsic benefits is essential for its preservation. By attracting private capital into conservation efforts, they can address funding needs that government and philanthropy alone cannot meet. Given the significant funding gap to prevent biodiversity loss­—estimated at over $700 billion annually—the hope is that, with proper safeguards and transparent operations, nature-preserving companies can meaningfully contribute to environmental preservation while offering investors the prospect of long-term returns.

Valuing nature within financial markets is an essential yet complex task that requires innovative approaches and careful considerations. While the current state of sustainable investment and nature-preserving companies offers some promise, significant challenges remain in ensuring that nature is adequately valued and protected. By addressing these challenges, we can create financial institutions that support economic development while promoting environmental sustainability.

The results of the recent US presidential election re-ignited a debate over the macroeconomic effects of tariffs, and the appropriate monetary policy response to a trade war. During the first Trump administration, US tariffs on Chinese exports rose seven-fold between 2018 and 2020, and they remained high under the Biden administration. More to the point, global political trends point to a significant weakening of global consensus regarding free trade and herald a new environment in which central banks may face this new type of shock with increasing frequency.

Much of recent research on the macroeconomic effects of trade policy shocks has been conducted in the context of real trade models, or in empirical exercises without consideration of monetary policy. But the consequences of trade frictions obviously challenge central banks: how should they respond to a backwards step in the progress towards increasing trade integration, with potentially significant effects on inflation, economic activity, external balances, and real exchange rates? In a recent paper (Bergin and Corsetti 2023), we study the optimal monetary policy responses to tariff shocks of various types. In this column, we update the analysis and distill lessons appropriate to the current situation.

In our paper, we study the optimal monetary policy responses to tariff shocks using a standard workhorse open-economy New Keynesian (sticky-price) model augmented with international value chains in production, i.e. imported goods are used in the production of domestic goods and exports. This implies that raising tariff protection of domestic exporters raises the cost of production for domestic firms. Throughout our analysis, we assume a share of imported inputs in production close to estimates based on the US input–output tables for 2011 (but we also verify our main conclusions varying this share). Our main analysis assumes substantial pass through of tariffs to consumer prices, but we also demonstrate robustness of our main results to enriching the model with a distribution sector that limits pass-through. Finally, we posit that monetary authorities do not take advantage of cross-border spillovers to pursue beggar-thy-neighbour policies, i.e. we rule out opportunistic manipulation of the exchange rate.

To sum up our main message: even if there is broad agreement that new Trump tariffs will likely be inflationary for the US, it is far from obvious that the optimal response of monetary policy to these tariffs should focus on fighting these inflationary effects via monetary contraction. Tariff shocks combine elements of both demand and supply disturbances, and monetary policy is bound to face a difficult trade-off between moderating inflation and supporting economic activity; in fact, a reasonable calibration of our model indicates that the optimal monetary response to such a scenario may well involve monetary expansion. Our analysis underscores that, while the optimal monetary response to tariffs depends on several factors, a key role is played by (i) the likelihood that the tariffs are reciprocated in a trade war, (ii) the degree of reliance of domestic production on imported intermediates, and (iii) the special role of the US dollar as the dominant currency for invoicing international trade. We discuss different cases in turn.

Let us consider first the rationale for monetary tightening. This would be clear in a scenario in which the US unilaterally imposes a tariff on domestic purchases of foreign goods to boost demand for domestic goods, causing inflation in the price paid by domestic consumers and producers using imported inputs.

In Figure 1, we use our model to trace the effects of a unilateral tariff shock. The dashed lines trace the effect of such a shock over time while holding policy rates constant: GDP and inflation rise in the US, but they move in the opposite direction in the US’ trade partner (the foreign country). At the ongoing exchange rate, the US trade balance turns into a surplus.

Looking at these baseline results, a policy of monetary contraction at home (US) can be motivated by a need to moderate inflation – corresponding to monetary expansion abroad to moderate deflation. But a further motivation can be found in the fact that the divergence in the home and foreign policy stance works to appreciate the home currency, which can serve to lower the effective price of foreign goods that home consumers see, and thus partly offset the distortionary effect of the tariffs on relative prices.

These considerations underlie the behaviour of macro variables under the optimal policy, traced as a solid line in the figure. The US monetary authorities curb inflation, which in our case serves also to moderate the domestic rise in output. The fall in demand and the dollar appreciation reduce the trade surplus somewhat. Abroad, monetary authorities support activity at the cost of inflation, contributing to correcting in part the international relative price of goods distorted by the tariff.

As we show in our paper, the conclusions so far remain valid also when the degree of exchange rate pass through is low across all borders, i.e. prices are sticky in the currency of the export destination country. A low pass through reduces the effect of currency depreciation on relative prices, and monetary policy cannot rely on currency depreciation to redirect global demand towards own traded goods. Yet, in response to a unilateral tariff, the optimal stance is still contractionary at home and expansionary abroad.

Where our paper is more innovative is in showing that the optimal policy is generally expansionary in the case of a symmetric tariff war – say, if the foreign country retaliates with equivalent tariffs on imports of US goods. In this case, the US experiences not only higher inflation but also a drop in output, driven by the fall in global demand induced by the hike in trade costs. Trade wars present policymakers with a choice between moderating headline inflation with a monetary contraction, or instead moderating its negative impact on output and employment with a monetary expansion.

The trade-off confronting central banks is illustrated by the dashed lines in Figure 2, drawn for a symmetric war, under the assumptions that the pass through of the exchange rate on border prices is very high. The contractionary effects of the tariff war include a deep drop in gross exports worldwide. Inflation spikes, while output falls.

A trade-off between inflation and unemployment is obviously not unfamiliar to policymakers. If it were generated by a standard supply shock – say, a fall in productivity – standard macro models would suggest optimal policy would choose monetary contraction to stabilise inflation. However, as stressed in our analysis, tariffs are quite different from a standard productivity shock, in that they combine elements of supply shocks with demand shocks, and the optimal policy consequently tends to be quite different. One way to see this is that while a tariff war raises the average price of all consumption goods, including imports, the contraction in global demand tends to reduce the prices set by domestic firms. In other words, tariffs raise CPI inflation but tend to depress PPI inflation. In a retaliatory trade war, it is optimal to expand and stabilise PPI inflation despite the hike in CPI inflation hitting consumers. This is shown by the solid lines in Figure 2, drawn for one country (the conclusion applies symmetrically of course to all countries engaging in the trade war).

While we have demonstrated above that tariff shocks are quite different from productivity shocks, it is also important not to confuse tariff shocks with cost-push markup shocks. First, a home tariff shock only affects the prices of imported goods, while markup shocks are typically envisioned as affecting domestically produced goods. Second, the revenue generated by a tariff shock accrues to the importing country, while the profits from higher markups go to firms in the exporting country. Third, tariffs are imposed directly on the buyer, thus added on top of the price set by the exporter. Our model highlights the unique nature of tariff shocks relative to these other supply disturbances; even while monetary contraction is the optimal response to adverse productivity or markup shocks in the context of our model, monetary expansion is the optimal response to a tariff shock generating inflation.

Our analysis fully accounts for the fact that production in the US uses a high share of imported intermediate inputs, i.e. higher production costs amplify the supply-side implications of the tariff relative to the demand implications. Indeed, in our quantitative exercises, we find that the optimal response to a trade war becomes contractionary at a particularly high share of imported intermediate inputs in production. But based on input–output estimates of this share (and extensive robustness analysis in which we vary the share), we believe that our benchmark conclusion (prescribing an expansionary monetary stance) can be expected to be more relevant empirically.

The US dollar has a special role as the dominant currency used in international trade of goods. It is well known that if the prices of imports in all countries are sticky in dollar units, the US (the dominant currency country) can rely to a much larger extent on monetary policy as a stabilisation tool. That is, it should be in a better position to redress the distortionary effects of the tariff shock on own output and employment, with relevant implications for the rest of the world.

Consider first a tariff war, depicted in Figure 3 (again, the dashed lines trace the no-policy scenario, the solid lines the optimal policy scenario). On impact, the war is a global contractionary shock. In the dominant currency country, the optimal monetary response is now relatively more expansionary, as the national monetary authorities can redress the lack of global demand without feeding the inflation of imported inputs at the border – imports in dollars move very little with a dollar depreciation. An expansion in the dominant-currency country is good news for the other country: it contains the fall in global demand and reduces imported inflation there (a dollar depreciation means that importers abroad pay a cheaper price in domestic currency at the border). Because of this, even if the tariffs hikes are perfectly symmetric, the other country is in a different position. Rather than matching the expansion in the US, it resorts to a mild upfront contraction to contain inflation. Note that, while GDP falls in both countries, it falls by less in the country issuing the dominant currency. The US dollar depreciates in this scenario.

As we discussed above, in the case that the tariff is unilaterally imposed by the dominant currency country, the global demand for exports by this country does not suffer the effects of a retaliatory tariff. Hence, inflation becomes a more pressing concern for monetary authorities – the optimal stance is contractionary. The contraction can now be stronger, because the dollar appreciation has more muted crowding-out effects on US goods in the international market. The stronger contraction has global repercussions. Abroad the optimal stance becomes expansionary – to prompt domestic demand vis-à-vis falling exports to the US – tolerating inflation and exacerbating currency depreciation. The US dollar appreciates sharply in this scenario.

Tariff shocks may present policymakers with a particularly difficult choice between moderating inflation and the output gap. Several factors of the current situation suggest that, even while tariffs are likely to be inflationary, it might be optimal for policy to focus more on the inefficient fall in output. These factors include the likelihood that US tariffs could be reciprocated in a tariff war, the fact that current tariff threats seem centred more on final consumption goods rather than intermediate inputs in domestic production, and the fact that the US dollar has an asymmetric position in world trade as a dominant currency.

Source：CEPR

There is no green transition without green investment. Stimulating this will be the core challenge for the European Green Deal in the next five years, making or breaking the European Union’s chances of achieving its climate targets and strengthening its competitiveness and security.

But how much green investment is really needed to achieve the EU climate targets? To assess this, good-quality country-level information is required. But despite the European Green Deal and the many initiatives it has triggered, this remains surprisingly incomplete and inconsistent. At best, some of the national energy and climate plans (NECPs) of EU countries provide general estimates of the amount of investment needed to reach the 2030 target, without specifying how such estimates were calculated, making it impossible to assess their reliability, compare them in a consistent manner or monitor progresss towards decarbonisation (ECA, 2023).

In the absence of reliable official national information, Europe’s green investment needs can best be grasped by looking at European Commission ex-ante estimates for the EU as a whole, in the impact assessments underlying the 2030 and proposed 2040 climate targets (European Commission, 2020, 2024).

According to the Commission, between 2011 and 2020, total investments in energy supply (ie power plants and the power grid), energy demand (ie buildings, industry, agriculture) and transport (ie cars, trucks, public transport) averaged 5.8 percent of GDP. Achieving the EU 2030 climate target will require additional annual investments of about two percent of GDP between 2021 and 2030, a level that must be sustained for two decades to reach net-zero (Table 1).

These estimates are broadly in line with the findings of Pisani-Ferry and Mahfouz (2023) for France and with global estimates from the International Energy Agency (IEA, 2023b), the International Renewable Energy Agency (IRENA, 2023) and Bloomberg New Energy Finance (BNEF, 2024) . They are also aligned with the estimates for additional green investment needs in 2025-2030 in the Draghi (2024) report on European competitiveness, which are themselves based on European Commission and European Central Bank calculations . Finally, Bizien et al (2024) confirmed that the gap between current EU climate investments and Commission estimates of future needs amounted in 2022 to around 2.5 percent of GDP.

The European Commission’s headline green-investment need estimates are flawed. The investment cost of some major items is overstated. Other important climate-related investment needs are not included. Even after adjusting for over- and understatements, the figures are subject to significant uncertainty.

The Commission’s headline numbers have transport as the main spending item by far, but 60 percent of this investment need would arise from replacement of cars that would happen anyway (based on an average car lifespan of around 10 years; ACEA, 2023). If this is taken out, the Commission expects additional transport investments consistent with reaching net-zero to be limited: 0.5 percent of GDP annually from 2021 to 2030. Instead, the power sector and buildings are expected to be the main sectors requiring additional efforts to achieve climate targets. In these two sectors, investment needs are expected to almost double as a share of GDP over the same period.

The Commission’s headline numbers also attempt to factor-in behavioural change. This is likely significant, as further behavioural measures (eg accelerated modal shifts and sustainable mobility patterns, energy conservation, recycling) could reduce EU green investment needs by about eight percent (Table 2).

The European Commission’s numbers refer only to capital expenditures (CAPEX) and do not include financing costs. This is worth mentioning because while CAPEX represents the main cost item in the green transition, the cost of financing investment will be significant for cash-constrained agents and public finances will need to step in with de-risking instruments to facilitate private investment.

The Commission’s numbers also only look at the deployment side of decarbonisation, and do not include its manufacturing side. That is, these figures do not take into account the clean-tech manufacturing costs required to reach EU industrial policy objectives, such as what is outlined in the Net-Zero Industry Act (NZIA, Regulation (EU) 2024/1735). The Commission estimates that ramping up clean-tech manufacturing capabilities in Europe to meet at least 40 percent of the EU’s annual deployment needs by 2030 would require additional total investments of about €100 billion in the period 2024-2030. This is about 0.1 percent of GDP.

We consider this estimate to be very conservative, in particular because the NZIA focuses only on a limited selection of technologies and domestic supply chains, and overlooks the costs of skill-enhancement programmes and of securing access to underlying strategic critical raw materials. In addition, green investment needs in manufacturing might be much greater if economic security is deemed to require aggressive reshoring.

Finally, the Commission’s estimates deal only with the mitigation side of climate action and do not include climate adaptation investment. This is a major gap, as the EU’s need for climate adaptation already is and will be substantial, even if mitigation proceeds on schedule. Estimates of adaptation investment involve considerable uncertainty. For the EU they are currently estimated to range between €35 billion and €500 billion annually, a huge range that reflects different underlying assumptions and methodological approaches (EIB, 2021a). It is urgent to narrow the range of plausible estimates and develop better assessment of the distribution of those investments over time and across countries.

The above estimates are underpinned by a number of assumptions, including on the trajectory of the carbon price, timing of decarbonisation efforts, the role of innovation in slashing clean-tech costs and system substitutability. These of course could change. It should also be clear that the estimates are only for decarbonisation investments, and do not include the other environmental and circular economy parts of the European Green Deal. Nor do they include the investments required to mobilise all the necessary resources, such as reskilling/upskilling of workers from brown to green industries and measures to tackle the social implications of climate policy. This last point is particularly relevant, because there will be a great need from 2025-2030 to deal with the complex distributional implications of buildings and transport decarbonisation, from which emissions reductions have so far been relatively small. Avoiding political backlash may involve offering financial incentives to households in return for adopting costlier green technologies.

To summarise: because behavioural changes could be more significant than assumed, the European Commission’s headline investment estimates could be overestimating overall and private mitigation-related investment needs (section 2.1). However, total climate-related transition needs should also include adaptation investments, the costs of reskilling and the cost difference between investment in green tech and the investment in brown tech that would otherwise have happened. The size of these excluded items in very uncertain, mostly because of uncertainty surrounding adaptation needs. Consequently, the total investment need for the green transition up to 2030 is likely to exceed the Commission’s estimates by a wide margin. This is even more the case for the transition up to 2040.

If achieving the EU climate goals requires a substantial increase in investment, who is going to pay? The European Commission does not provide specific figures for this, mentioning only that the private sector is expected to be the main source of investment in the electricity system and industry, while public funding is expected to play a substantial role in the buildings and transport sectors, and in supporting innovative clean-tech uptake in the energy system and the industrial sector.

EIB (2021b) and Darvas and Wolff (2022) estimated the public share of green investment to be about 25 percent. However, these exercises are characterised by high uncertainty. For instance, by providing estimates for each category of investment, Pisani-Ferry and Mahfouz (2023) estimated this share to be higher for France: 50 percent in an optimal scenario for the country, also because of France’s larger public sector and greater share of public buildings than other countries. This higher figure is in line with a granular analysis by Baccianti (2022) for the EU, the central scenario of which also points to a roughly 50 percent public share of green investment.

Based on these different exercises, we can assume the public share of additional green investments from 2025-2030 to range between 25 percent and 50 percent. Given that the annual additional investments to reach the EU 2030 climate target are estimated at two percent of GDP, the additional public effort to reach the EU 2030 climate target would thus range between 0.5 percent and one percent of GDP over 2025-2030.

Given limited public finances, it will be crucial to make all the necessary efforts to stay at the lower end of this range. In other words, the available resources should be focused on those areas where private finance alone cannot deliver (ie where clear market failures exist). This includes:

R&D support and support for early adoption of innovative clean technologies. This is what allows the creation of economies of scale, leading to steep cost reductions, which in turn progressively reduce the need for public support as the ‘green premium’ thins out. This has happened with wind and solar energy. IRENA estimated that between 2010 and 2022, the average cost of generating electricity from solar PV fell by 89 percent – currently almost one-third cheaper than the cheapest fossil fuel globally – while the cost of generating electricity with onshore wind fell by 69 percent. This is why countries including Germany have been able to rethink their investment support for renewables, and why the share of public investment to meet EU climate targets in the power sector is estimated in the relatively low range of 15 percent to 20 percent (Baccianti, 2022).

Financing electricity and transport infrastructure, as well as renovation of public buildings. For example, public funding will need to pay for a significant share of investment in railway networks, public transport and district heating (Baccianti, 2022; OBR, 2021).

Provision of financial de-risking tools to lower the cost of capital for private investors in green projects. Many clean technologies are characterised by high CAPEX and low operating costs (OPEX). This is true for wind and solar generation, electric vehicles and buildings retrofitting. The cost of capital thus plays a key role in the green transition, providing a critical benchmark to assess the risk and return preferences of investors, and acting as a lever for financial flows to influence prices and choices in the real energy economy (IEA, 2021). Lowering the cost of capital to foster private investment can be done through instruments such as preferential loans and guarantees to both firms and households. For instance, zero-interest loans in France, granted under the éco-Prêt à Taux Zéro (éco-PTZ) programme boosted energy-renovation rates across the country thanks to high take-up among the middle class (Eryzhenskiy et al, 2022).

Provision of direct financial support and compensation to the most vulnerable to ensure a socially fair transition. For most vulnerable households, direct public support is needed to compensate for the higher energy costs linked to climate policy, and to ensure take-up of green alternatives. For example, the phase-in of an EU carbon price on household and road transport emissions will likely be regressive, disproportionally affecting vulnerable households that rely on fossil fuels for domestic heating and lack the resources needed to change their vehicles. Directing support to the most vulnerable would help reduce both emissions and energy poverty. For instance, prioritising grants for the worst-performing buildings, often occupied by vulnerable consumers, will yield climate benefits and benefits in terms of improved air quality, health, productivity, energy security and lower future government outlays to alleviate energy poverty (Vailles et al, 2023; Keliauskaite et al, 2024).

The upshot is that the EU has embarked on a transformational transition without mapping out in detail how much investment this transition will require, and without equipping itself with the capacity to monitor, either at EU-level or national level, the actual efforts and the remaining investment gap. Knowing the rough direction of travel is like crossing the Atlantic without a compass, and is not enough.

Even if governments can ensure the substitutability of public finance with private finance, achieving the EU’s 2030 climate goal will still require public investment during 2025-2030 of at least 0.5 percent of GDP. Delivering this will be tough for five main reasons.

Since the launch of the European Green Deal in 2019, the EU has played an increasingly direct role in fostering green investment, including through carbon pricing and regulations, and also by offering financial incentives. Balancing prohibitions and incentives is crucial to ensure the political viability of the green transition and to avoid a dangerous ‘blame game’ with national capitals (Pisani-Ferry et al, 2023). Two major steps have been taken on the financing of the green transition. First, its was decided to set a 30 percent minimum green spending threshold in the EU budget (the multiannual financial framework, MFF), amounting to about €1 trillion for 2021-2027. Second, a 37 percent minimum green spending threshold was established for the main part of the NextGenerationEU post-pandemic instrument, the Recovery and Resilience Facility (RRF), which was endowed with financial firepower of €723 billion for 2021-2026, including €338 billion in grants.

The RRF is currently the largest source of EU grants for the green transition, especially for buildings and transport decarbonisation (Lenaerts and Tagliapietra, 2021). On top of the MFF, green grants from the RRF and other instruments – the Innovation Fund, the Modernisation Fund and the Just Transition Fund – amount to about €50 billion per year.

But the RRF ends in 2026. This will leave a major gap in EU funding for the green transition, which will decrease to slightly less than €20 billion per year. In other words, a gap of about €180 billion for the 2024 to 2030 period will open up (Pisani-Ferry et al, 2023). This is highly problematic. It will happen just as EU countries are required to deepen their decarbonisation efforts substantially, starting with difficult sectors such as buildings and transport. The risk of political pushback from national capitals will likely be serious as a result.

A reform of the EU’s fiscal framework – which implements the EU Treaty requirement for countries to keep their budget deficits within 3 percent of GDP, and their public debt within 60 percent of GDP – took effect in April 2024. The framework as updated imposes restrictions that could make the financing of new green investment at national level very difficult for countries with debts and deficits considered excessive. Furthermore, the reformed fiscal framework does not include a ‘green golden rule’, which would exclude any increase in net green public investment from the fiscal indicators used to measure compliance with the fiscal rules. Nor does it provide exemptions even for EU-endorsed national green investments (see Box 1). These constraints make public investment for decarbonisation harder to realise.

There have been just four soft landings in history — in 1968, 1985, 1995, and now, in 2024. Because soft landings are so rare, market participants don’t have a lot of data points to make bold predictions about the future. But, historically, economic growth has accelerated in the years following a soft landing. And that pattern is likely to repeat in 2025.

The soft landing outcome has propelled stocks to all-time highs in 2024. Meanwhile, credit spreads are historically tight and most measures of market volatility are tranquil. Solid corporate profits are forecast to accelerate throughout 2025, especially in the US. And the Trump administration’s policy goals — including deregulation, lower energy costs, and tax cuts — could boost an already growing US economy.

The Federal Reserve Bank of Atlanta GDPNow forecast suggests that the economy will expand at a 2.6% annual rate in the fourth quarter of 2024.Most forecasts predict that US GDP will grow by 2% to 2.5% in 2025, far from recession territory.

The labor market remains resilient. The US has added more than 2.1 million jobs in the past 12 months. The unemployment rate is at a historically low 4.1%.Wages are growing faster than inflation. And businesses are reluctant to lay off workers, a positive leading indicator for the economy.

Fully employed consumers are likely to keep spending. The top 20% of income earners are responsible for 40% of consumption,and they are in great shape.

Somebody’s consumption is somebody else’s profit. S&P 500® companies are projected to grow their earnings by 9.4% in 2024. Remarkably, analysts are forecasting even better earnings growth of 15% in 2025. If S&P 500 companies deliver on earnings, already lofty profit margins would reach all-time highs.

At the same time, inflation continues to crawl back toward the Federal Reserve’s (Fed) 2% target. The Fed’s preferred inflation measure, the Core Personal Consumption Expenditures (PCE) Price Index, has fallen by 0.4% over the past 12 months, from 3.2% to 2.8%.

There’s an old market adage that claims economic expansions don’t die of old age. The implication is that a catalyst is needed to end the good times.

Yet, elevated valuations have rarely been a good predictor of short-term stock market performance. Expensive investments can, and often do, get more expensive in the near term. Failure to meet or exceed sky-high earnings expectations next year could disrupt the market’s rally. Resurgent inflation also could thwart the economic expansion, but rising inflation is more likely a 2026 problem than a 2025 problem. Ultimately, the direction of real interest rates may be the final arbiter on whether this expansion lives or dies.

Still, standing on the precipice of 2025, it’s difficult to envision any of these visible risks as the impetus for an economic contraction and an end to the market’s rally next year.

What did the economy withstand to achieve a soft landing in 2024? From March 2022 to July 2023, the Fed raised interest rates 11 times, the most aggressive pace in 40 years. Fed policymakers increased the target range for the federal funds rate from 0% to a peak of 5.25% to 5.50%. These rate hikes helped cool inflation from a peak of 9.1% in June 2022 to 2.6% in October 2024.

Despite all the rate hikes, the economy avoided recession and the labor market endured. Defying the odds, the Fed slowed the economy enough for inflation to fall, but not so much that it slipped into recession.

Economic growth has slowed from a 4.9% annual rate in the third quarter of 2023 to a 2.8% annual rate in the third quarter of 2024.The unemployment rate climbed from 3.4% in April 2023 to 4.3% in July 2024, signaling a softening labor market.And, with the target range for the federal funds rate notably above current measures of inflation, the Fed began its interest rate-cutting cycle in September, slashing interest rates by 0.75% at its last two meetings. With rates at 4.50% to 4.75% in November, most Fed watchers expect the central bank to cut rates by another 0.75% to 1.00% in 2025.

So, what happens next?

History doesn’t repeat itself, but it often rhymes. The Fed’s tightening cycle prior to the most recent soft landing in 1995 was also aggressive.

From February 1994 to February 1995, the Fed raised interest rates seven times over 13 months. Inflation wasn’t the culprit then; it was an overheating labor market. The Fed doubled the target range for the federal funds rate from 3% to 6% without causing a recession. Fearing that monetary policy conditions had become too tight, the Fed made a series of mid-cycle adjustments, cutting interest rates three times by 0.75% from July 1995 to January 1996. Following the 1995 soft landing, US GDP accelerated from 2.7% in 1995 to 3.8% in 1996.

Today’s Fed mid-cycle adjustments could produce a similar bump to the US economy in 2025.

As the Fed aggressively raised rates through July 2023 to defeat inflation, capital formation plunged.

Initial public offerings (IPOs) are now well below the average of the past 20 years. Mergers & acquisitions (M&A), hindered by higher rates and a tougher regulatory environment, are below 10-year averages.Private equity firms have $3.2 trillion in assets in their portfolios just waiting for an exit plan. Private equity deal values have fallen 60%, deal count has plummeted by 35%, and exit values are down 66%.Businesses' capital expenditures have been constrained by higher rates and stiff regulations, especially in manufacturing industries.

Fed rate cuts combined with lower potential energy costs, lighter regulation, and lower taxes could unleash a period of massive capital formation through IPOs, M&A, and increased capital expenditures. Artificial intelligence (AI) also has the potential to bolster economic growth, increase productivity gains, and create the next wave of innovative new businesses.

The 1995 soft landing also included an enormous increase in computing power that intersected with the global adoption of the Worldwide Web by both consumers and businesses. This fostered an era of exceptional economic growth and the Greenspan productivity miracle.

In fact, the years following the 1995 soft landing up until the TMT Bubble burst in March 2000 were some of the greatest years on record for stock market performance. The S&P 500 returned 37.2% in the 1995 soft landing year, on its way to five consecutive years of annual returns above 20%. Could the year-to-date S&P 500 return of 28.1% in 2024’s soft landing be the start of another historic bull market run?

No pain, no gain. That exceptional post-soft landing bull market run from 1995 to 1999 came with far greater volatility than today’s investors are accustomed to. Some market observers blame the Fed’s monetary policy decisions for causing the Thai baht currency crisis, Russian debt default, and Long-Term Capital Management (LTCM) failure.

Simultaneous transitions in government leadership, monetary policy, and fiscal spending are likely to increase capital market volatility in the current post-soft landing period. Greater market volatility may be the price market participants pay for faster economic growth and potentially higher stock market performance.

The current bull market celebrated its second birthday on October 12, 2024. On average, a bull market lasts a little more than five years. And if the current bull market ended now, it would be one of the shortest on record. Building on the solid gains of the past two years, the current environment suggests the rally may continue in 2025.

What does that mean for investors looking to position portfolios for the year ahead?

Within equities, the Fed’s easing cycle, strong US economic growth bolstered by the Trump administration’s policy goals, and AI-related leadership point to opportunities in US small caps, regional banks, and the broad AI value chain.

Within fixed income, while monetary policy has been the recent driver of interest rate trends, expected trade tariffs, immigration reform, and tax cuts all mean fiscal policy also will likely impact interest rate volatility in 2025. But the Trump administration’s pro-business policies may boost credit’s favorable outlook.

Finally, structural shifts in leadership, monetary policy, and fiscal spending have contributed to the high correlation between stocks and bonds that has destabilized traditional portfolios, making now a good time to consider diversifying to restore balance and help temper a potential increase in volatility.

The government has published a policy statement outlining its plans for local government funding in England next year, and providing further details on longer-term reform plans.

IFS associate director and head of devolved and local government finance David Phillips said:

“The announcement on council funding is a clear statement of intent from the new government.

If all English councils increase their council tax by the maximum allowed (on average, just under 5%), their overall core funding would increase by 5.6%, or 3.2% in real-terms after accounting for forecast economy-wide inflation. And add on new income from the producers of packaging, and the increase will be closer to 5% in real-terms.

But funding increases will be very much targeted at deprived, typically urban, councils. Grants targeted at rural councils are to be abolished to part-fund a new deprivation-based grant. The government is at pains to point out that councils serving rural areas will still see a boost to their overall funding, but this will be substantially smaller than in more deprived areas.

The government has described these changes as a stepping stone to more fundamental reforms from 2026-27 onwards. Its commitment to reform the council funding system with updated assessments of spending needs and local revenue-raising capacity is welcome – and long overdue. Existing funding allocations are based on a range of ad-hoc decisions and data from back as far as the 1990s. The current system is simply not fit for purpose and the government is right to reform it.

The changes made for the coming year suggest these longer-term changes will also have an emphasis on redistributing funding to more deprived areas, to offset cuts they bore the brunt of during the 2010s. Whether that is fair will be in the eye of the beholder. The status quo could not continue indefinitely though, and a forthcoming consultation will allow councils and other stakeholders across England their say on what a reformed funding system should prioritise.”

Head of Global Short Duration Daniel Siluk believes that an extension of the economic cycle in the U.S. and suspect growth elsewhere create an opportunity for bond investors to capture attractive yields and preserve capital by diversifying globally.

In assessing the prospects for global bonds in 2025, investors must consider the inextricable links between the shifting macro and policy environments. In the U.S., even prior to November’s election, markets were calibrating expectations for the Federal Reserve’s (Fed) easing cycle. The combination of a resilient labor market and inflation falling perhaps not as rapidly as hoped lessened the urgency to cut rates as an extension of the economic cycle was priced in.

In many respects, the election of former President Donald Trump increased the likelihood of sustained economic growth, but it also introduced new uncertainties that bond investors cannot ignore. While pro-growth initiatives such as deregulation and tax reform could spur investment and consumption, tariffs and trade barriers could be inflationary at the very least and – at worst – present potential hindrances to global growth should these measures be reciprocated.

Already interest rates have taken notice. The U.S. Treasuries yield curve has risen across all tenors. Shorter-dated yields reflect a more subdued rate cut trajectory, and longer-dated yields have risen as investors account for greater volatility, potentially higher growth, and the possibility that the battle to fully tame inflation isn’t over.

Facing acute headwinds, other regions – much of Europe, for example – may have to be more deliberate in easing policy. It will be the responsibility of investors digging into the details to determine which regions, sectors, and securities will be net beneficiaries of the incoming administration’s policies and which may face new headwinds.

From an investment perspective, diverging economic and policy prospects create both opportunities and risks for bond investors. Across jurisdictions, the battle against inflation has sent yields to levels that can again provide investors with attractive income streams.

The outlook for rates is evolving, however. With Europe facing floundering growth, bond yields may continue to fall farther, representing an opportunity for capital appreciation along the front end of sovereign curves. In the U.S., any pro-growth initiatives or barriers to trade may alter the pace of inflation’s downward trajectory. This could lead to additional volatility in mid- to longer-dated Treasuries.

As different regions travel their own economic and policy paths, investors with a global view have the opportunity to increase diversification within fixed income allocations by incorporating issuance with attractive yields and securities in regions where rates may fall.

One must also consider what’s already been price into markets. In the U.S., for example, the nominal yield on the 10-year note has risen by as much as 80 basis points (bps) since mid-September, with rising expectations for inflation over the next decade accounting for a considerable portion of the increase.

We believe a similar global approach should be applied when seeking opportunities within corporate credits. Diverging economic prospects have implications for corporate issuers’ credit profiles. And with valuations elevated across the asset class, investors have the opportunity to seek out regions where stabilizing – or improving – economic conditions should fortify an issuer’s ability to meet its obligations. In contrast, where growth is more tenuous, richly valued and more cyclically exposed issuance is best avoided.

Furthermore, valuations in some regions appear more favorable than others, often for the same credit rating – or even specific issuer. With volatile currency exposure hedged away, global investors can maximize the potential for excess return with little or no incremental increase in risk.

One way to navigate the still-uncertain economic environment is to focus on shorter-dated corporate issuance. Higher yields relative to much of the past 15 years have resulted in the potential to generate attractive returns due to the steeper roll down of these securities as they near maturity. Over these shorter time horizons, investors tend to have better visibility into an issuer’s ability to service its debts. The rationale for a focus on the front end is reinforced by still-low term premiums, meaning investors are potentially exposing themselves to considerably more volatility for only marginally higher returns.

We expect to gain greater insight into President-elect Trump’s economic priorities during the early months of his administration. His team’s approach to trade, deficits, and the economic aspects of his national security agenda will reverberate globally. Pro-growth initiatives would likely keep Treasury yields high relative to global peers. The accompanying dollar strength would come at the expense of other currencies and also funnel a greater share of global investment toward the U.S. This could aggravate the economic positions of regions like Europe. And to the degree this agenda would alter expected growth trajectories, it would inevitably influence the decisions of the Fed and other central banks.