Climate Shocks and Inflation: Heterogeneity, Persistence, and Implications for Monetary Policy

Abstract This paper investigates how climate shocks affect consumer price inflation in a broad range of countries over a period of five decades, using local projection methods. Climate change is likely to lead to more frequent and more severe supply and demand shocks that will present a challenge to monetary policy formulation. The analysis finds that the impact of climate shocks on inflation depends on the type and intensity of shocks, as well as the country’s income level. While adverse climate shocks resemble negative supply-side shocks and exert inflationary pressures in the short term, their impact on the demand side can sometimes dominate over the medium term and reduce inflation. Droughts tend to have the highest positive impact on inflation overall, primarily reflecting rising food prices. Interestingly, floods tend to exert a dampening impact on inflation, resembling Keynesian supply shocks. Over the long run, the dominant monetary policy paradigm of flexible inflation targeting, when faced with supply-induced climate shocks may become increasingly ineffective, especially in LIDCs. Further research is needed to identify viable alternative monetary policy frameworks.