The link between climate change and inflation explained

There is little doubt that climate change represents one of the greatest societal and economic challenges of this century (Weder di Mauro 2021). The need for action is gaining urgency by the day, of which the delegates to the United Nations COP26 conference, taking place as we are writing, are keenly aware. Human-induced climate change is already affecting observed weather and climate extremes across the globe.

Central banks are not the primary actors in the fight for preventing climate change, but they can play an important supporting role and have been paying increasingly closer attention to its impacts. For example, the ECB has a climate action plan following the recent conclusion of its review of monetary policy strategy (Drudi et al., 2021), and the Network for Greening the Financial System has grown from the eight founding members in 2017 to over 100 members and observers today. Yet the implications of climate change on inflation have received surprisingly little attention in the literature.

There are three main channels through which climate change can affect central banks’ primary mandate of price stability:

At the same time, when considering the implications for the conduct of monetary policy, it is also important to consider how widespread and how durable the impact on inflation is, as monetary policy is geared towards medium-term inflationary pressure. While shocks to one sector may affect relative prices, in theory relative price adjustment could be thought as independent from economy-wide inflation and monetary policy could therefore ‘look through’ the impact. However, because relative price adjustment can first show up as inflation and the process can be protracted, a medium-term effect on inflation is certainly possible. Indeed, we know that only a small fraction of inflation is ‘pure inflation’, namely, an equi-proportional rise in all prices (Reis and Watson 2010); the remaining part of inflation variability entails some relative price adjustment.

The prospect of a lasting influence on inflation of relative price changes depends crucially on the credibility of the monetary policy regime. A spike in oil or commodity prices, for example, only has a temporary effect on overall inflation if inflation expectations are well anchored (Choi et al. 2018, Gelos and Ustyugova 2017). This is also visible in the very different response of overall inflation in most advanced economies to oil price increases in the 1970s and in the Great Moderation period. Even in a low-inflation regime, however, relative prices can be important for overall inflation. Peersman (2021), for example, finds that exogenous shifts in global food prices explain almost a third of medium-term inflation variability in the euro area.

In contrast to inflation, several pieces of empirical work study the impact of climate change on economic activity, in particular on the effect of disasters triggered by natural hazards, particularly the ‘Big Four’ of floods, droughts, windstorms and earthquakes (e.g. Noy 2009, Strobl 2011, Fomby et al. 2013, Felbermayr and Groschl 2014).¹ The consensus is that such events generally reduce economic activity in the near term, particularly in developing economies and for more severe events.

The impact of extreme temperatures on economic activity has received little attention until recently (e.g. Dell et al. 2012, Acevedo et al. 2020, Colacito et al. 2019). The literature agrees here as well that higher temperatures depress economic growth, especially in developing economies. Season also matters, with summer heatwaves particularly damping economic activity.

Turning to the implications of climate change for inflation directly, a few studies look at the effect of the Big Four natural hazards on prices (e.g. Heinen et al. 2019, Parker 2018), while there is almost no research on the effect of extreme temperatures, apart from studies focusing on specific sectors of activity (e.g. De Winne and Peersman, 2018, 2021).

In a new paper (Faccia et al. 2021) we investigate how extreme temperatures affect various measures of prices: consumer prices (including the food and non-food components), producer prices, and the GDP deflator. Studying extreme temperatures may be informative as to the effects stemming from a more generalised and sharp increase in temperature from human induced climate change.

We run panel regressions for 48 advanced and emerging economies, regressing various price indicators on the seasonal divergence of temperatures from their country-level average in the middle of the 20th century (1951-1980) on price developments. We also construct alternative measures of temperature anomalies, to account for a gradual process of adaptation to higher temperatures. Finally, we consider additional explanatory variables – such as the importance of the contribution of the agricultural sector to GDP – to obtain some insight on the transmission channels.

Our empirical analysis is backed by a theoretical framework, which consists in a simple two-country, two-good New Keynesian model enriched with a role of temperature in influencing productivity for the weather-sensitive (food) sector, in order to rationalise the effect of temperature shocks on overall price developments. One key finding of the model analysis is that high temperatures lead to a sharp rise in food prices, but medium-term inflationary pressure is muted or even negative. This resonates with some of our empirical findings.

Overall, we identify four key results:

Figure 1 Effect of hot summer weather shocks on inflation and its components

Notes: Impulse responses to hot summer temperature anomalies at horizon 0 for advanced economies (displayed in blue) and emerging market economies (displayed in red). The dependent variable is the cumulative price growth between t+h and t-1. The results for the GDP deflator – not shown here - are similar to those for PPI. Shaded areas represent 68% and 90% confidence intervals computed using Driscoll and Kraay (1998) standard errors.

We find that higher temperatures over recent decades have played a non-negligible role in driving price developments, including into the medium term and especially for emerging economies. Climate change, in other words, is already starting to bear on the primary mandate of central banks, although for advanced economies it does not yet appear to play a major role. Overall, this provides some empirical basis for central banks to contribute to global efforts to combat climate change, which is rooted in their primary mandate.

Authors’ note: The views expressed belong to the authors only. We thank Irene Heemskerk and Isabel Vansteenkiste for helpful comments.

Acevedo, S, M Mrkaic, N Novta, E Pugacheva, and P Topalova (2020), “The effects of weather shocks on economic activity: what are the channels of impact?”, Journal of Macroeconomics 65.

Choi, S, D Furceri, P Loungani, S Mishra, and M Poplawski-Ribeiro (2018), “Oil prices and inflation dynamics: evidence from advanced and developing economies”, Journal of International Money and Finance 82: 71-96.

Colacito, R, B Hoffmann, and T Phan (2019), “Temperature and growth: a panel analysis of the United States”, Journal of Money, Credit and Banking 51(2-3): 313-368.

De Winne, J and G Peersman (2018), “Agricultural price shocks and business cycles: a global warning for advanced economies”, Ghent University Working Paper No. 18/945.

De Winne, J and G Peersman (2021), “The adverse consequences of global harvest and weather disruptions on economic activity”, Nature Climate Change 11(8): 665-672.

Dell, M, B F Jones, and B A Olken (2012), “Temperature shocks and economic growth: evidence from the last half century”, American Economic Journal: Macroeconomics 4(3): 66-95.

Drudi, F et al. (2021), “Climate change and monetary policy in the euro area”, ECB Occasional Paper Series No. 271.

Faccia, D, M Parker and L Stracca (2021), “Feeling the heat: extreme temperatures and price stability”, ECB Working Paper, forthcoming.

Felbermayr, G and J Groeschl (2014), “Naturally negative: the growth effects of natural disasters”, Journal of Development Economics 111: 92-106.

Fomby, T, Y Ikeda, and N V Loayza (2013), “The growth aftermath of natural disasters”, Journal of Applied Econometrics 28(3): 412-434.

Gelos, G and Y Ustyugova (2017), “Inflation responses to commodity price shocks - How and why do countries differ?”, Journal of International Money and Finance 72(C): 28-47.

Heinen, A, J Khadan, and E Strobl (2019), “The price impact of extreme weather in developing countries”, Economic Journal 129(619): 1327-1342.

Noy, I (2009), “The macroeconomic consequences of disasters”, Journal of Development Economics 88(2): 221-231.

Parker, M (2018), “The impact of disasters on inflation”, Economics of Disasters and Climate Change 2(1): 21-48.

Peersman, G (in press), International food commodity prices and missing (dis)inflation in the euro area”, Review of Economics and Statistics.

Reis, R and M W Watson (2010), “Relative goods' prices, pure inflation, and the Phillips correlation”, American Economic Journal: Macroeconomics 2(3): 128-157.

Strobl, E (2011), “The economic growth impact of hurricanes: evidence from US coastal counties”, The Review of Economics and Statistics 93(2): 575-589.

Weder di Mauro, B (ed.) (2021), Combatting Climate Change: A CEPR Collection, CEPR Press.

1 Clearly, not all these natural hazards are due to climate change (for example, earthquakes). Still, studying the effects of these natural disasters may be informative for understanding the climate change-induced increase in the frequency of some of these episodes.