The Asymmetric Effects of Weather Shocks on Euro Area Inflation

This research paper published by the European Central Bank (ECB) examines the effects of weather shocks on euro area inflation. The results show that these shocks have asymmetric effects and non-linear impacts that vary by country and season, and introduce significant volatility into prices throughout the year.

The paper examines how temperature shocks – both in terms of mean temperature and variability – affect inflation in the four largest eurozone economies: Germany, France, Italy and Spain, as well as the euro area overall. It makes an important contribution to the literature on climate-economy relationships and uses a macroeconometric framework, combining monthly information on output growth and inflation with high-level meteorological data.

The results show that increased mean temperatures substantially affect inflation when shocks occur in summer and autumn, mainly via food and services prices, with a particularly pronounced effect in warmer countries. For instance, significant upwards pressure on euro area inflation persists for more than 12 months if heatwaves occur in Spain during summer.

The response of food prices to temperature variability also tends to be inflationary as changing weather increases uncertainty and disturbs the production of crops. Though in contrast to high mean temperature shocks, inflationary effects of temperature variability manifest when the shock occurs outside of the summer months.

The findings also reveal a heterogeneous effect of variability shocks on aggregate inflation within the euro area. While higher variability outside of summer puts upward pressure on euro area inflation in Germany, France, and Spain, it has a downward effect if it arises in summer.

The results have material consequences for price stability mandates, say the authors, as weather shocks are increasingly common and projected to increase. Global warming is also likely to exacerbate climate-related price volatility as the inflationary impacts are strongest in countries with warmer baseline climates. As a result, rising temperatures may result in economic shocks similar to those in Spain materialising “across a larger set of euro area countries”.

The research allows for important non-linearities by using seasonally dependent Bayesian Vector Autoregressions for each country and the whole euro area. However, the authors also note several limitations of the study which does not include weather shocks outside the EU or other types of economic shocks.

The authors state that future research should develop additional indicators for weather extremes, study impacts using more granular price data and include further non-linearities.