Feeling the Heat: Extreme Temperatures and Price Stability

This European Central Bank (ECB) study examines the impact of country-specific temperature shocks on prices across 48 advanced and emerging market economies. It finds that “temperature plays a non-negligible role in driving medium-term price developments” and warns that the impact of heat on inflation is non-linear.

Following a comprehensive literature review, the paper examines how extreme temperatures affect medium-term inflation, using panel local projections to compare temperature anomalies in each country with a range of prices. These include food and non-food consumer prices, producer prices and the GDP deflator. It introduces a simple two-country New Keynesian model incorporating the effects of temperature on productivity for agricultural goods, with data on seasonal divergence of temperatures from the 1951-1980 average.

Four main conclusions are identified from the analysis. By far the largest and most durable price impact is from hot summers, but that impact differs at the sub-index level with the short-term impact most notable on food prices. The time horizon also matters, with evidence that short-term supply disruption in agriculture can result in more longer-lasting downward pressure on demand, leading to negative inflation dynamics in the medium term.

The study also finds that the impact of heat events on inflation is non-linear, both in terms of divergence from average temperatures, and in terms of absolute temperature. “This suggests that even for those countries where the impact has been limited to date, the future may be less benign,” the authors warn.

“Climate change matters for price stability,” the paper concludes. It follows a similar discussion paper recently published by the German Institute for Economic Research examining the impact of natural disasters on price stability in the euro area. That paper found significant positive effects on overall headline inflation as a result of extreme weather events, but also found diverging results at the sub-index level.