Global warming and heat extremes to enhance inflationary pressures

The economic effects of climate change are increasingly understood, with empirical studies demonstrating impacts on labor productivity, agricultural output, energy demand, and human health from historical weather fluctuations. These micro and macroeconomic impacts translate into considerable welfare losses. However, the impact of weather on inflation and the implications for future climate change remain understudied. Understanding this is crucial because rising or unstable prices threaten economic and human welfare, as well as political stability. The 2021/2022 cost-of-living crisis exemplifies these implications, with estimates suggesting a significant increase in global poverty due to rapidly rising prices. The potential impact of climate change on inflation dynamics is highly relevant for monetary policy and central banks' ability to maintain price stability. Previous work has identified historical weather impacts on inflation, but assessments of implications under future climate change are lacking. This study provides a comprehensive assessment of historical impacts on inflation from various weather conditions, accounting for heterogeneity across seasons and regions. By combining these results with projections from physical climate models, the study assesses the implications of these impacts under projected future climate change conditions.

Existing research has explored the relationship between weather fluctuations and inflation, focusing on the effects of average temperatures, temperature variability, and annual precipitation. Studies have shown a correlation between temperature increases and inflationary pressures, particularly impacting food prices due to reduced agricultural productivity. However, a significant gap exists in assessing the long-term implications of these historical impacts under the context of future climate change projections. This paper bridges this gap by incorporating climate model projections to analyze the potential inflationary pressures resulting from projected changes in temperature and other weather variables.

The study combines measures of national exposure to various weather conditions, using high-resolution data from the European Centre for Medium-range Weather Forecast Reanalysis version 5 (ERA5), with a dataset of monthly price indices for different goods and services across 121 countries (1996-2021). This provides over 27,000 observations. The empirical framework quantifies the causal effects of weather fluctuations on national, month-on-month inflation rates using fixed-effects panel regression models. Country-fixed effects account for unobserved differences between regions, while year fixed effects account for contemporaneous global shocks. Country-month fixed effects account for country-specific seasonality. The baseline specification includes country-specific time trends to avoid spurious correlations. This methodological approach strengthens confidence in causal interpretations by controlling for a wide variety of confounding factors. The study uses lagged weather variables to assess the persistent effects of weather shocks on inflation. Additional weather variables considered include daily temperature variability (standard deviation of daily temperatures within each month), and monthly precipitation extremes (Standardized Precipitation Evapotranspiration Index, SPEI). Robustness tests were conducted using alternative specifications, including dynamic panel models, Driscoll-Kraay errors for cross-sectional correlation, and explicit controls for changes in monetary policy frameworks. The study also considers income level and historical inflation volatility to examine the consistency of effects across different groups. For future warming projections, an ensemble of 21 bias-adjusted climate models from the Coupled Model Intercomparison Project Phase 6 (CMIP-6) under different emission scenarios from the Shared Socioeconomic Pathways (SSPs) was employed. The impacts estimated using future climate projections are considered as the effects of future weather conditions on inflation, assuming no unprecedented adaptation, no targeted monetary policy response, and abstracting from interactions with macroeconomic developments. Uncertainty analysis encompasses empirical specification choices, emission scenarios, and climate model projections. Cumulative marginal effects are calculated to depict the overall impact of a climate shock on inflation over time.

The study finds a strong, nonlinear relationship between temperature increases and inflation. Higher temperatures consistently increase food and headline inflation persistently over 12 months, impacting both high- and low-income countries. The response to temperature is nonlinear, with larger inflationary impacts in hotter months and regions. Increases in average temperatures at higher latitudes have varying effects depending on the season, while increases at lower latitudes consistently cause upward inflationary pressures year-round. Increased daily temperature variability also significantly increases food and headline inflation, with larger impacts at lower latitudes. Excess wet conditions cause persistent upward impacts on food and headline prices, while the effects of excess dry conditions are less consistent. The impacts of average temperature increases on inflation are robust across various tests and specifications, including those considering income level and historical inflation volatility. This suggests limited historical adaptation to temperature increases. Projections to 2035 indicate significant upward pressures on food and headline inflation globally, with larger pressures in the global south. By 2060, the magnitude of pressure diverges sharply depending on the emission scenario, highlighting the potential for mitigation efforts to reduce inflationary pressures. Analysis shows that adaptation through adjustment to changing temperatures could substantially reduce future impacts, especially under low emission scenarios; however, in unmitigated warming scenarios, substantial pressures would remain. The study further finds that projected climate change will alter the seasonality of inflation, increasing seasonal variability in some regions and decreasing it in others. Analysis of the 2022 European heatwave shows a significant impact on food inflation. Climate change is projected to amplify the inflationary effects of such extreme heat events, with the amplification factor varying based on the emission scenario.

The findings address the research question by demonstrating a significant and persistent causal link between higher temperatures and inflationary pressures. The results highlight the significant threat posed by climate change to price stability and broader economic welfare. The robust nature of the findings, which hold across various income levels, regions, and empirical specifications, underscores the widespread and potentially severe consequences of climate change. The study demonstrates that historical adaptation has been limited, suggesting that significant inflationary pressures can be expected unless substantial mitigation and adaptation measures are implemented. The implications for monetary policy are substantial, as climate change may complicate the identification and management of inflationary pressures, necessitating a more comprehensive framework. The identified seasonal and regional heterogeneities in inflation responses to temperature increases highlight the need for differentiated policy responses and underscore the potential for increased economic inequality.

This study provides robust evidence of the significant and persistent impact of climate change on global inflation. The results underscore the need for policymakers to incorporate climate-related risks into macroeconomic models and policy decisions. Future research should explore the effectiveness and cost-effectiveness of different adaptation strategies, as well as the potential for innovative technological solutions to mitigate the inflationary pressures associated with climate change.

The study acknowledges limitations in providing a comprehensive relationship between all weather conditions and inflation. The use of national-level data may limit the detection of local effects of precipitation changes, and a limited response of price aggregates beyond food and headline inflation was observed. Future research could address these limitations by utilizing higher-resolution data and expanding the analysis to encompass more price aggregates. The study also assumes constancy in factors beyond climate conditions, such as macroeconomic developments and consumption patterns, in assessing future inflationary pressures; this represents a simplification of a complex system.