Climate change increases inflation risks – ECB paper

Climate change will make monetary policy-makers’ task increasingly hard, research published by the European Central Bank finds.

One effect of climate change it to increase the difficulty in distinguishing between temporary and permanent inflationary shocks, the paper finds.“This makes it even harder to forecast inflation accurately,” write Friderike Kuik, Wolfgang Modery, Christiane Nickel and Miles Parker. 

“Moreover, the uneven impact of climate change on countries makes it more challenging to conduct monetary policy in the euro area, since it may increase inflation differentials between member states.”

“The longer we delay the transition of our economies, the greater the damage will be,” say the authors. “In turn, procrastination will complicate the ECB’s task of delivering price stability.” 

Extreme heat can contribute to both higher inflation and higher inflationary volatility, the authors find. “Food inflation could rise by around 1.8 percentage points in an extreme summer in 2060’s climate, relative to a hypothetic scenario without any climate change,” they write.

The authors say firms might find fewer opportunities for profit due to reduced potential output, which could push banks to decrease lending rates. “This would reduce the policy space available to central banks to stimulate the economy during downturns,” say the researchers. 

The effectiveness of monetary policy may also be harmed by deteriorating loan quality as climate change makes repayment more difficult.

The authors warn that climate change could decrease potential output. Storms could destroy infrastructure, and reduced snowfall and rising sea levels could threaten tourism. Workers need to be protected from extreme heat, while droughts could harm the transportation of freight.

Adaptation could help. But the authors say there is a significant gap in climate insurance in Europe. 

The process of adaptation is also costly, they say. They warn we would “likely see an increased strain on public finances, which could reduce the scope for stabilising fiscal policies and even impinge on fiscal soundness”.