The Impact of Climate Change on Price Stability

This policy briefing from E-axes Forum reviews recent literature on the impact of extreme weather events on inflation. Based on a series of webinars with contributions from senior economists and researchers from the European Central Bank, Bank of England, Federal Reserve and Bank for International settlements, it suggests that central bankers must act on climate change in order to secure price stability and fulfil their primary mandates.

The paper examines the theory and empirical evidence for climate change impacts on inflation, focusing on three questions: whether climate change is a supply or demand shock, or both; whether carbon pricing has an inflationary effect; and if climate change should be included in the mandates of central banks.

According to recent literature, there is clear evidence of physical climatic influences on inflation, especially through rising food prices. In particular, the report focuses on a 2021 European Central Bank study which shows that “temperature plays a non-negligible role in driving medium-term price developments” and that the impact of heat on inflation is non-linear. Overall, the literature suggests that the effects of heat and drought cause short-term supply shocks translating into medium-term demand shocks, especially in emerging economies.

The paper then turns to carbon pricing, showing that it has a minor effect on inflation and may even be deflationary. A carbon tax increase is seen as a one-off shock with only a temporary inflationary effect, while the transition to renewable alternatives that such a tax encourages can reduce prices.

Although the review does not come to a clear conclusion on incorporating climate change into central bank mandates, it makes clear that “monetary authorities should be aware of the impact of extreme weather events on inflation”.

“In order to secure price stability and to fulfil their primary mandate, policymakers should act promptly and in a differentiated manner,” the review concludes. It points towards interest rate management, expectation anchoring, financial stabilisation and cooperation with fiscal authorities as some of the tools available to central bankers in making monetary policy resilient to climate change.