The Effects of Natural Disasters on Price Stability in the Euro Area

This discussion paper from the German Institute for Economic Research examines the impact of natural disasters on price stability in the euro area, and finds significant positive effects on overall headline inflation but diverging results at the sub-index level.

The study combined estimated damages of disaster events with monthly data for the Harmonised Index of Consumer Prices for all euro area countries between 1996 and 2021. In addition, 12 main sub-indices and a further sub-category for food price inflation were examined, allowing the separation of differences in the direction and strength of price effects across consumption categories. In addition, structural vector autoregression models were run for the four largest euro area economies: France, Germany, Italy and Spain.

The results suggest that natural disasters have significant positive effects on overall headline inflation and particularly pronounced positive inflation effects for food and beverage prices. However at the sub-index level results diverged, with heterogenous inflation effects of natural disasters seen across different countries.

The analysis considered only the physical impacts of climate change on inflation, and transition impacts were not examined. The European Environment Agency estimates that physical climate-related extreme weather events caused economic losses of €446bn in European Economic Area countries between 1980 and 2019.

The paper concludes that, as global warming accelerates, climate-induced inflationary pressures in the euro area are likely to increase, making it more challenging for the European Central Bank (ECB) to achieve its inflation target in the future. However the different inflation effects of weather-related disasters in different countries will make it difficult for the ECB to align inflation rates across countries while satisfying the needs of individual member states.

Given the effect of climate change on the ECB’s ability to achieve its inflation target, the central bank must consider its use of monetary policy and prudential tools to contribute to emissions reduction, said paper author Ulrich Volz. “Contributing to an alignment of financial markets with a net-zero pathway in order to prevent catastrophic climate change is the best way for the ECB to mitigate climate-induced disruptions to its ability to achieve price stability.”