Temperature shocks already influencing US monetary policy – report

August 9, 2022|Written by Graham Caswell|Federal Reserve

A recent study from a Bank of Italy economist has found that surprise temperature shocks in the US have been “significantly hurting” the economy over the past 50 years. The analysis, summarised in an article published by the Centre for Economic Policy Research’s VoxEU portal, suggests that climate-related shocks have reduced GDP and consumer prices, leading to an expansionary monetary policy and revisions of Federal Reserve economic forecasts.

Based on the assumption that economic agents adjust their beliefs about prevailing temperatures over time, daily average temperature data for each US county since 1975 was compared against five-year averages to identify quarterly temperature “surprises” that differ from expectations. The approach is based on the idea that unexpected exceptionally hot and cold weather is what matters in the short run, reflecting the continuous adaptation of agents to the increasingly frequent temperature extremes.

County-level temperature extremes were then aggregated to obtain a US-wide temperature shock, which was compared against key economic variables.

The study showed that exceptional temperatures have had a negative effect on GDP for up to 16 quarters following the shock, reducing both private consumption and investment. Temperature shocks also reduced the consumer price index (CPI), although with a greater lag than GDP effects.

Analysing the impact of temperature shocks on the short-term interest rate suggests that, on average, the Fed has reacted by lowering policy rates. Comparisons against the Fed’s GDP and CPI forecasts also suggest an influence, with the Fed reacting to shocks by adjusting both its nowcasts and short-term forecasts for both variables.

However, while the Fed appears to be reacting to the economic effects of temperature extremes, it does not seem to recognise climate and temperatures as a source of economic shocks. A textual analysis of all Federal Open Market Committee meetings between 1976 and 2015 showed little mention of climate change or temperature shocks. The committee did increase its mention of temperatures following shock events, the study found, but this increase was tiny.

“Results show that temperatures are an autonomous source of macroeconomic variation, adding another piece of evidence in the debate on the needed policy response to climate change,” the study concludes, suggesting that the methodology used can be replicated for other countries and modified to examine other weather-related shocks.

This page was last updated August 9, 2022

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