Inflation as an Ecological Phenomenon

As climate change and fossil fuel dependency increasingly drive global inflation, “orthodox monetary policy is counterproductive to achieving price stability” according to this report from finance advocacy group Positive Money. Meeting environmental targets and transitioning to renewable energy are now imperative for maintaining price and macroeconomic stability, say authors David Barmes and Jordi Schröder Bosch.

Hiking rates in response to climate-related price shocks undermines efforts to address the core ecological drivers of price instability, fossilflation and climateflation, necessitating a fundamental rethink of monetary policy.

Climateflation refers to inflationary effects from climate change’s physical impacts, primarily through reduced agricultural yields and food price increases.

By 2035, research projects rising temperatures could add up to 3.23 percentage points to annual global food inflation and 1.18 percentage points to headline inflation, with low income countries disproportionately affected. Single-country studies have found that extreme weather events and shocks have resulted in higher food prices in China, Thailand, Peru, Germany and the UK.

Inflationary pressures will only intensify if the climate and environment continue to deteriorate resulting in “recurring, persistent and escalating supply and demand shocks”with substantial cross-border implications.

Fossilflation stems from the high volatility of fossil fuel prices, which subject economies to sudden and severe price shocks. Throughout 2022 and 2023, high headline inflation figures across the globe were driven primarily by rising energy prices, state the authors. In the UK, direct effects of energy prices, along with the indirect effects on energy-intensive goods and services, accounted for 75% of inflation at its peak of 11.1% in 2022.

In the US, prices of petroleum and coal products alone contributed nearly 1.5 percentage points to headline inflation between 2020 and 2021.

Fossilflation also has global reverberations that disproportionately impact lower-income countries, a trend which has strengthened with the US becoming a net energy exporter. Since mid-2021, as the dollar strengthened alongside rising energy prices, net energy-importing countries have been exposed to a “double whammy” of increasing commodity prices and contracting GDP, alongside tightening dollar credit conditions and rising borrowing costs.

The report argues that central banks’ traditional response of raising interest rates is often an ineffective response to climate- and energy-induced price volatility. Rate hikes fail to address underlying supply shocks, hamper green investments and further reduce fiscal space for government-led climate action.

For many global south economies, interest rate hikes, particularly from the Federal Reserve, can trigger capital outflows and currency depreciation, forcing them to raise rates even higher and exacerbating debt distress. Following the recent cycle of rate hikes, 60% of low-income countries were at high risk of, or already in, debt distress due to record debt servicing costs, according to the World Bank.

Instead, the report calls for central banks to incorporate environmental considerations into their inflation forecasting and macroeconomic models as well as their policy frameworks and operations. This includes greening collateral frameworks, asset purchase programs, and targeted lending schemes.

It also advocates for greater coordination between monetary, fiscal and industrial policy to manage inflation while supporting the green transition.

Internationally, the report recommends new monetary arrangements to give global south countries more policy space for climate action, including increased special drawing rights issuance, expanded multilateral development bank lending, more concessional finance, and debt suspension measures.