Acute Physical Impacts From Climate Change and Monetary Policy

Climate change poses a growing threat to global price stability, requiring financial regulators to prepare for an increasingly uncertain economic future, according to this Network for Greening the Financial System (NGFS) study. The report outlines a framework for understanding the non-linear macroeconomic impact of weather-related damages and their monetary policy implications.

Experts agree that economic damages from severe weather events will rise significantly with global temperatures, state the authors. Annual global direct costs from weather-related hazards have more than doubled in real terms since the early 2000s, a trend likely to continue as events intensify and become more frequent.

The report explores how physical impacts propagate through the economy via supply, demand and financial channels. 

Supply-side effects are usually felt first and include the destruction of productive capital and infrastructure, displaced workers, job losses, reduced productivity, and impacts on public financing. In contrast, demand is primarily affected by adverse effects on household wealth, income, and market and consumer confidence. The financial sector magnifies shocks caused by reduced asset prices and increased default rates – which have negative consequences for collateral value, equity prices and balance sheets – through knock-on effects on credit conditions and lending volumes.

The authors also highlight a potential diabolic loop between a weakened banking sector and increased climate-related sovereign debt risk. Climate disasters increase government spending needs and can result in sovereign credit rating downgrades which exacerbate bank distress and raise the likelihood of bank bailouts. These factors place additional strain on national finances and in turn lower sovereign creditworthiness further.

These effects have substantial implications for price stability and other key macroeconomic variables, including output and GDP. Inflation impacts depend on whether supply or demand effects dominate as well as the specific nature and context of the hazard, states the report. 

The NGFS suggests central banks may struggle to forecast the non-linear effects on inflation within historical error ranges, introducing greater uncertainty into their core tasks. Shifting severe weather patterns can also impact global savings and investment, altering the long-run natural rate of interest, and constraining monetary policy space to accommodate shocks.

Improved adaptation measures and insurance coverage are identified as key factors to limit economic fallout. However, currently, more than half of global losses from physical hazards are uninsured, exceeding 90% for many economies in the global south, including China and India. 

Economic effects will likely be uneven, with the scale of damages dependent on how well the financial infrastructure can support reconstruction efforts. As a result, developing economies may face larger shocks from similar-magnitude disasters. However, international spillovers can be considerable, particularly through commodity prices and supply chain disruptions, meaning high-income countries aren’t immune to the economic consequences.

The authors review methodological approaches commonly used to model climate hazards’ economic implications, emphasising the importance of considering three key dimensions: hazard characteristics, economic exposure, and vulnerability. They also highlight the value of disaster databases and meteorological, spatial, and socio-economic datasets.

The report stresses the need for more research, particularly regarding the shifting distribution of severe weather events, compounding effects of multiple events, and the impact of various adaptation and mitigation policies.