What’s up with the weather (and what might it mean for inflation)?

September tends to signal the end of the summer and, as we learned from Met Éireann on Monday, this summer was among the five warmest on record. July was also the hottest month in recorded history, and saw multiple extreme heatwaves in the Northern Hemisphere.¹

Climate scientists believe that the maximum temperatures recorded in July would have been “virtually impossible” in the absence of climate change.²

Therefore, not only are we grappling with the consequences of increased average temperatures from climate change, but we must also consider the impact of the more extreme weather events that we see in the news much more frequently, including heatwaves, heavy rain, intense tropical cyclones, and droughts.³

In the near-term, we can also expect increased temperatures to be driven by an emerging El Niño event, a recurring pattern of warmer waters in the East Pacific. The onset of El Niño has recently been announced by the World Meteorological Association, and episodes typically last for nine to 12 months.⁴  El Niño events can lead to dramatic changes in climate in affected regions, and have been forecast to become more frequent and severe due to climate change.⁵

With more extreme weather events a distinct possibility, we are not living in any kind of stable “new normal”, but an ongoing process, a “new abnormal”, as climate scientist Michael E. Mann puts it. 

Heatwaves, in particular, can have profound impacts on health and wellbeing.⁶ The full health impact of extreme heat takes time to ascertain, but we know the effects can be dire. One recent study estimated the 2022 summer heatwave led to over 60,000 heat-related deaths in Europe.⁷  Heatwaves are also associated with deadly wildfires, such as we have seen in many European and North African countries this summer. Wildfires themselves release carbon dioxide into the atmosphere, and we already have evidence for large 2023 wildfire emissions in Canada and Greece.

While this blog is focussed on economic effects of the increasing number of extreme weather events, we must not forget that the overriding cost is a human one.

Recent heatwaves have coincided with very high inflation, and while some inflationary pressures are easing, it is still well above our target of 2%.⁸ The large shocks that initiated this period of very high inflation – such as energy and food commodity prices – are unwinding, but recent extreme weather may add to food price inflation, which has already been high for some time. 

We need to understand how the weather, and climate change more generally, can drive inflation. In this blog I thought I would consider the prospects for so-called “heatflation”⁹, and look at the ways in which weather and climate change may shape European monetary policy in the future.

How are economies affected by extreme weather?

Extreme weather events inflict direct damage on our economies. And the effects can be persistent. This means that they impact the growth rate of output, compounding the initial direct effects.¹⁰

Beyond any direct physical damage, one transmission channel of extreme weather events are the effects they have on food prices. Higher and more volatile prices result from less predictable agricultural productivity and supply in increasingly hotter and drier conditions, where weather is more variable.

Energy prices also respond to weather events, a particular concern in Europe given the precariousness of imported energy (notably gas) supply. It was only a year ago that policy makers – including my colleagues and I on the ECB’s Governing Council – were looking for briefings on the prospects of a mild European winter. 

Price increases could also become more persistent when affected by multiple subsequent or interconnected shocks – so-called “compound extremes”¹¹  – for example if we see prolonged drought conditions interacting with an acute heatwave event. For agriculture-producing and exporting countries, the overall impact depends on the relative price and quantity effects. But swings in global food prices also spill-over to other economies via imported food price inflation.¹²

Beyond the direct effects from higher commodity prices, there are many potential channels linking extreme weather events to inflation, and they can work in opposing directions.¹³ 

After energy, manufacturing goods prices could be affected by reduced labour productivity from extreme heat. The strengths of these productivity effects would likely differ across economies, based on whether they are on average hotter or cooler, and could be mitigated by measures such air conditioning.¹⁴  Prices in services could also increase due to reduced productivity, and more frequent extreme weather could affect both demand and supply in the tourism sector. Such forces would affect core inflation, the more persistent form of inflation, so we begin to see how weather events can begin to impact the medium term inflation outlook. 

Extreme weather events can also, through the destruction they inflict, reduce aggregate demand and confidence in the economies that are affected. These demand effects would act to reduce inflation in the medium-run. So far, the evidence suggests that extreme weather can have short-run positive impacts on inflation, especially food-price inflation, but there may be deflationary effects in the medium-run.¹⁵

Regarding El Niño events, the strength and persistence of economic effects will depend on the extent to which countries are exposed.¹⁶ Given many climate models predict a greater frequency of severe El Niño events in the future, this would generate additional major economic losses that are typically excluded from current frameworks, such as Integrated Assessment Models, designed to calculate the economic costs of climate change. Past El Niño events have been found to lead to short-run inflationary pressures.¹⁷

Different regions of the world may have differing exposures to extreme weather events, but we cannot see things only through a national lens since our actions (or inaction) will have strong impacts on others. Climate change is therefore a form of what economists call an “externality”, and it has been called “the mother of all externalities”.¹⁸  

Looking further ahead

I have highlighted some of the evidence we have so far accumulated regarding extreme weather, and we know that these events will occur with greater frequency and strength with rising global temperatures. 

However, there are some thorny issues relating to how best to use the evidence we have on past events, when extrapolating into the future.

The reason is that though given weather events may do a certain amount of economic damage today, we cannot necessarily say that such events will do similar amounts of damage in a future where the probabilities of these events has generally shifted upwards. This is sometimes referred to as the problem of the “weather versus climate response”.¹⁹ 

On the one hand, the adaptation of production processes to the changing environment, also thanks to the development of new technologies and the reallocation of factors of production such as capital and labour, could limit the long-run impacts of climate change.

On the other, there is the risk of an intensification of the effects of extreme weather when these events happen repeatedly. In this case we could underestimate the costs of extreme weather in the future, were we to attempt to add up the effects of shocks occurring today.²⁰

The issue that the patterns observed historically may not remain true in the future is a limitation shared by all models designed to make predictions.

Still, all major central banks and economic institutions use models for their forecasts, and constantly revise and update them to learn from forecasting errors and improve the accuracy of their predictions.  At the end of the day, quantitative modelling provides an important aid to our understanding of how best to achieve our mandate of price stability.²¹  

But, with climate change, quantitative modelling approaches are challenged by an additional and crucial issue: though central bankers must always deal with high levels of uncertainty, the levels of uncertainty associated with climate change are far higher than anything we are used to. The different future scenarios we are forced to consider include potentially catastrophic ones.²² 

One issue that arises when determining how monetary policy should deal with the effects of climate change is that of the interpretation of shocks, in particular understanding their persistence and whether they are driven by supply or demand effects. 

A weather event (even a particularly adverse one such as El Niño) would traditionally fall under the category of ‘temporary supply shocks’ and, as such, would warrant no response from monetary policy in most circumstances. This is the idea of central banks “looking through” supply shocks.  

Depending on the duration and nature of the shock, the strength of second-round effects – for example, if workers respond to unexpected inflation surges via higher wage demands that are inconsistent with price-stability – and many other contingencies, potentially stronger responses to supply shocks may be required in some cases.²³

In addition, in a world buffeted by multiple extreme weather events, each of which has uncertain impacts, we will have to be especially careful to “look through” only when we are confident such a strategy is warranted.

As recently underlined by Nobel laureate Lars Peter Hansen, the most impactful place for an effective climate policy is in the fiscal realm, in the context of a co-ordinated response from governments around the world.²⁴

Monetary policy, however, can support these actions, in line with the ECB’s secondary objective of supporting the general economic policies of the EU.

A world of price instability is not a world in which we can deal effectively with climate change, and price stability is what our monetary policies are designed to achieve. We need to understand the effects of climate change itself on our economies, and on inflation dynamics. In the world of the “new abnormal” and climate change, as monetary-policymakers the only effective approach will be to continuously refine and adapt our understanding over time.

Gabriel Makhlouf