Recent academic literature has shown that climate change has significant implications for inflation. First, climate-related events (such as hurricanes, draughts, heatwaves and floods) can lead to supply-side disruptions that can increase inflationary pressures − the so-called ‘climateflation’ (Schnabel, 2022). Physical supply-side effects of climate change include the reduction in labour and capital productivity, the destruction of capital equipment, the decline in agricultural productivity and the increase in crop output failures (Beirne et al., 2021a; Storm, 2022). Climate-related physical changes can also affect the demand side of the economy, since they can lead to a decline in consumption and investment. For example, households might increase precautionary saving and firms might reduce investment due to uncertainty about profitability (Dafermos et al., 2018).
There is evidence that climate-related events have already affected inflation across the globe. For example, Parker (2018) finds that the impact of weather-related disasters on inflation is significant and persistent in low-income and middle-income counties, but less significant in high-income countries. He also shows that the effects on inflation differ between disaster types, a finding that is consistent with the empirical results of Kabundi et al. (2022). Beirne et al. (2021a) focus on the euro area and show that disasters have, on aggregate, a positive effect on inflation, with heterogeneous results across inflation sub-indices. Using a sample of high-income and medium-income countries, Faccia et al. (2021) find that hot summers tend to increase food price inflation in the short run. However, in the medium term this impact is insignificant or negative. Kunawotor et al. (2022) find a positive impact of weather-related disasters on inflation in African countries. Moreover, higher temperatures tend to increase inflation according to the empirical results of Ciccarelli et al. (2023) and Kotz et al. (2023).
Second, the policies that might be implemented for achieving the transition to a net zero economy (such as carbon pricing and environmental regulation) can lead to increasing costs for firms which might be passed on to prices − the so-called ‘fossilflation’ (Schnabel, 2022). For example, the climate scenarios that have been developed by the Network for Greening the Financial System (NGFS) show that in the case in which carbon prices increase significantly in the coming years the impact on inflation can be substantial (NGFS, 2023). The econometric literature is a bit less conclusive. Moessner (2022) finds that carbon prices have a positive impact on inflation in OECD countries. Santabárbara and Suárez-Varela (2022) show that cap- and-trade systems have increased inflation volatility in OECD countries – the same is not, however, the case for carbon taxes. Konradt and Weber di Mauro (2023) do not find significant effects of carbon taxes on inflation in Europe and Canada. However, all these empirical studies should be treated with caution: carbon prices have so far been relatively low, and inflation might react differently in the case in which carbon prices increase abruptly in the future.
Third, green technologies, such as electric vehicles, solar panels, wind turbines and batteries rely extensively on minerals like copper, lithium and nickel. If the green transition takes place within a short time period, it might be inevitable that some of these minerals will face excess demand and this can lead to inflationary pressures (see also Storm, 2022). Schnabel (2022) has called this possibility ‘greenflation’.
Central banks have limited control over most of these climate-related inflationary sources. For example, an increase in prices caused by a climate-related food supply shock cannot be addressed by increasing interest rates. Or, if governments decide to increase carbon prices as part of their decarbonisation plans, an increase in interest rates can do little to address the fossilflation that this increase can cause. Of course, central banks can affect demand by increasing interest rates. However, this is unlikely to be sufficient to keep inflation under control, unless perhaps interest rates increase substantially, which could have severe side effects, including debt repayment problems and increases in unemployment rates.
But, on top of it, climate change also impairs the so-called transmission channels of monetary policy, including expectations channels, credit channels and asset price channels (NGFS, 2020). For example, climate change can overall make the banking system more financially fragile. This can be the case due to both transition and physical risks (Battiston et al., 2021; Campiglio et al., 2018; Semieniuk et al., 2021). Transition risks capture the impact that an abrupt climate transition might have on the financial position of carbon-intensive companies which can then have spillover effects on the financial system. Physical risks are associated with climate-related economic disasters or financial losses that stem from gradual global warming and climate events, and can lead to an increase in defaults on household and corporate loans or asset price declines.
The fact that the financial system is exposed to these climate-related financial risks implies that in a scenario, for instance, in which central banks reduce interest rates to stimulate credit in a period of low inflation, this might have very negligible effects on credit provision, as banks might be under-capitalised or might find it difficult to identify creditworthy borrowers. The climate exposure of the financial system might also result in asset prices being unresponsive to changes in interest rates.
Overall, these fundamental changes in the determinants of inflation and the transmission channels of monetary policy call into question the ability of central banks to control inflation. Controlling inflation in the future might require a more systematic use of other instruments that are under the control of governments, such as price caps or product market policies that prevent oligopolistic structures.”
Yannis Dafermos (2024), The climate crisis meets the ECB: tinkering around the edges or paradigm shift? SOAS Department of Economics Working Paper No. 264, London: SOAS University of London (accessed online at https://www.soas.ac.uk/sites/default/files/2024-07/economics-wp264.pdf)
WHEN COMPLEX IS AS SIMPLE AS IT GETS 