Extreme weather events are growing in size, power and frequency, meaning our economies are increasingly disrupted. We show how this results in climateflation, which poses a dilemma to the ECB’s policymaking. In a world plagued by supply shocks induced by climate change, conventional monetary policy faces complicated trade-offs in terms of economic activity and prices, while at the same time proving incapable of tackling the source of inflation.
Climate change is increasingly disrupting our economic system. Last summer saw olive oil production in Spain and rice production in Italy plunge because of droughts, while hydropower generation plummeted in the EU due to extreme temperatures, and nuclear production in France halted due to a lack of water. By altering production, these disruptions directly affect prices, leading to climateflation.
Climateflation is distinct (but related) to fossilflation. The latter refers to the rise in fossil fuel prices and is currently the main worry for policymakers. Yet the consumption of fossil fuels accelerates global warming, and thus contributes to climateflation, that is, inflation linked to the disruptions caused by the increased occurrence and size of extreme weather events.
How extreme weather impacts inflation
Research on the relationship between climate change and inflation is still in its infancy. However, researchers are investigating the impact that natural hazards have on inflation, as climate change increases the likelihood of these events (IPCC, 2021). According to the World Meteorological Organization, disasters triggered by weather-, climate- and water-related hazards have increased fivefold in the last 40 years.
Climate change is difficult to predict and model, especially as there are major unknowns such as tipping points. While we do not know the exact path climate change will take in the future, researchers are beginning to understand how climate change-induced natural hazards affect inflation.
Early research focused on the impact of single events, and often found that these events had little (Doyle & Noy, 2015) or no effect (Cavallo, Cavallo & Rigobon, 2014) on inflation. A second generation of studies looked at a series of multiple events over time and, usually, over a large sample of countries, making such studies more reliable. These more recent studies have found that hurricanes and floods (Heinen, Khadan & Strobl, 2019), extreme temperatures (Faccia, Stracca & Parker, 2021; Mukherjee & Ouattara, 2021), or storms (Bao, Sun & Li, 2022) have significant inflationary effects.
When a sufficient sample of both developed and developing economies is analysed, studies found that the inflationary impact in developing countries is larger (Faccia, Stracca & Parker, 2021; Parker, 2018) and more persistent (Mukherjee & Ouattara, 2021). Finally, the impact of natural hazards is found to be nonlinear (Faccia, Stracca & Parker, 2021; Kim, Matthes & Phan, 2022; Parker, 2018), which means that the impact is disproportionately greater for larger events. This is a warning that, as the frequency and intensity of natural hazards increase, so will their inflationary impact.
Zooming in on the euro area, Bremus, Dany-Knedlik & Schlaak (2020) found that extreme rains and droughts have a negative effect on industrial production in France, Italy, and Germany. Studying the inflationary impact for Germany alone, they found that consumer prices (excluding electricity) tend to decline while agricultural prices tend to increase due to these extreme events.
Beirne et al (2022) found that headline inflation (HICP) in the euro area as a whole increases after a natural disaster. The authors also showed that natural disasters impact HICP sub-categories differently, affecting most notably food prices. Disaggregated by country, they found that while natural disasters have inflationary effects in the medium term in some countries (Italy and Spain), they have a deflationary impact on others (France and Germany). This heterogeneous response can result in inflation differentials across the euro area, which would decrease the effectiveness of the ECB’s monetary policy transmission.
Events across the globe drive climateflation
The studies above help us understand the inflationary impact of natural hazards at the national level. However, they don’t investigate the global drivers of inflation. As our economies become more interconnected, global factors are becoming increasingly essential to understanding inflation dynamics (Auer, Borio & Filardo, 2017, Forbes, 2019).
This is especially true for advanced economies (Parker, 2017), where inflation, especially in food and energy, can be explained by global factors. This means that natural hazards which happen in countries that export to the euro area may be as relevant to understanding domestic inflationary dynamics as domestic hazards.
Peersman (2021) shows that swings in international food prices explain on average 25%-30% of consumer price volatility in the euro area. Therefore, natural hazards that disrupt food production elsewhere will strongly impact euro area inflation. De Winne & Peersman (2021) find that harvest and weather disruptions increase global agricultural commodity prices, which then reduces real GDP and increases domestic prices. Interestingly, the pass-through from agricultural commodity prices to real GDP is more pronounced in advanced economies because they are net importers of agricultural commodities, have a smaller agricultural sector, and are more integrated into global markets.
Going forward, the way natural hazards affect imported inflation will be key to understanding climateflation in the euro area. Therefore, we need more research on how climate change-related events happening in the global economy – such as bad harvests or global supply-chain disruptions – affect particular economies.
Climateflation: a conundrum for the ECB
In a world of constant supply shocks, interest rate policy will prove largely ineffective, as we are currently experiencing. In 2018, Benoît Cœuré, then an executive member of the ECB’s Governing Council, already acknowledged the difficulty this creates when he asserted that: “weather-related disturbances typically pose a dilemma for central banks, which may then have to choose between stabilising inflation or economic activity”.
The ECB is much more comfortable when inflation is induced by demand because, in that case, economic activity and inflation move in the same direction. In such a context, the ECB can stabilise both inflation and demand by changing the interest rate. The same does not apply when inflation is driven by supply, as economic activity and inflation move in opposite directions. This forces the ECB to navigate a tricky trade-off.
Imagine a storm that negatively impacts food production, reducing its output and increasing its prices. If this takes place in isolation, the ECB can ignore this supply shock and wait for it to subside. Yet, if the storm is followed by more events, the ECB won’t be able to ignore its persistent effects. It then would face the dilemma of having to tame rising prices through interest rates, which would deepen the negative effect the shock(s) already had on economic activity.
Historically, the ECB has been able to ignore the impact of natural hazards. This may no longer hold if the size and persistence of these shocks increase. In a world plagued by supply shocks induced by climate change, interest rate management faces complicated trade-offs in terms of economic activity and prices, while at the same time proving incapable of tackling the predominant source of inflation: supply disruptions.
This short literature review leads us to two main takeaways. First, even if the necessity to speed up the green transition has been recently underlined by Christine Lagarde and Fabio Panetta, the ECB’s efforts to incorporate climate change into its operations still lack ambition. As we have established, climate change has a straightforward impact on the ECB’s primary mandate of controlling inflation. This comes on top of the risk that climate change poses to financial stability and the fact that climate change is part of the ECB’s secondary mandate. We have shown that the ECB does not lack incentives – or excuses – to step up its game in promoting the green transition. Second, conventional policies are proving ineffective in dampening supply shocks, which calls for a rethink of our policy toolkit. We need less damaging, more targeted tools that can directly affect the root cause of supply shocks.