Inflation around much of the world has returned close to target, but new inflationary risks loom.
Many of these risks lie on the supply side of the economy and many are related to climate change. Physical hazards such as droughts, floods and heatwaves can damage agricultural output, disrupt critical infrastructure and reduce labour productivity – driving up costs in essential sectors, particularly food and energy (see figure 1).
Exacerbated by other features of the polycrisis, such as environmental degradation and geoeconomic fragmentation, increasingly frequent, severe and persistent climate-induced supply shocks could pose major challenges for inflation-targeting central banks. Monetary policymakers will need innovative approaches to adequately calibrate their policy stance in response.
Persistent inflationary pressures in a hot and volatile world
To date, the inflationary effects of climate-related physical hazards have tended to be short-term, but evidence suggests their magnitude and persistence will increase disproportionately as such hazards become more severe under intensifying climate change, especially if climate policies are delayed or insufficient. Projections suggest that by 2035, rising global temperatures could contribute up to 3.23 percentage points annually to food inflation and 1.18 percentage points to headline inflation globally.
Figure 1. How climate change produces (dis)inflationary pressures. © CETEx
Beyond physical hazards, interconnected crises could compound these risks. Biodiversity loss, geopolitical tensions and disorderly energy transitions could further destabilise prices. Together, these forces risk a reversal of the favourable conditions that defined the “Great Moderation” of the late 20th century, when positive supply shocks led to output expansion with lower costs that anchored inflation expectations and enabled economic stability. Instead, the world may now face a “Great Reversal” or “Great Volatility” characterised by supply-side disruptions and heightened price instability.
Projections suggest that by 2035, rising global temperatures could contribute up to 3.23 percentage points annually to food inflation and 1.18 percentage points to headline inflation globally.
Challenges and trade-offs for monetary policy
Flexible inflation-targeting monetary policy regimes dominant in central banking today are typically centred on reaching a 2% target on a medium-term (typically two-year) policy horizon, using the policy rate as the main inflation control tool. Under such frameworks, supply shocks that are temporary can be “looked through” without significant policy adjustments. When supply shocks become recurrent or persistent – which could happen as climate change intensifies – monetary tightening becomes the standard policy response (see figure 2), but that comes with significant trade-offs.
Figure 2. Typical monetary responses to different types of negative supply shock. © CETEx
Excessive monetary tightening can exacerbate the recessionary effects of supply shocks and place stress on financial systems, as higher rates can increase credit default risk and destabilise financial institutions’ balance sheets. Higher interest rates also increase government borrowing costs, leaving less fiscal space to achieve economic, social and environmental goals. Moreover, monetary tightening can deepen inequalities, as low-income households bear the brunt of reduced economic activity. Lastly, excessive tightening risks delaying the green transition as it might disproportionately affect capital-intensive green investment and the development of green patents, undermining efforts to mitigate climate change and ensure long-term economic stability.
Central banks need a framework that keeps the benefits of flexible inflation targeting and balances medium-term inflation control with the imperative of building long-term economic resilience.
A framework for adaptive inflation targeting
Given these challenges, central banks need a framework that keeps the benefits of flexible inflation targeting and balances medium-term inflation control with the imperative of building long-term economic resilience. To navigate this tension in an era of persistent negative supply shocks and supply-side volatility, we propose a practical discussion on shifting from “flexible” to “adaptive” inflation-targeting (adaptive-IT).
Its key features would be:
- new inflation targets: adaptive-IT would apply either wider inflation target bands or a higher numerical target during periods of persistent supply-side disruptions. This flexibility would allow central banks to accommodate climate-related inflationary pressures without over-tightening;
- extended policy horizons: to better balance medium-term inflation with longer-term macroeconomic stability, adaptive-IT would extend monetary policy horizons to three years or more, providing additional scope for “looking through” supply shocks and considering the longer-term supply-side effects of monetary policy;
- expanded toolkits: adaptive-IT would integrate the existing monetary toolkit with new instruments focused on supply-side resilience and macroprudential tools that account for climate-related risks and address the root causes of supply shocks.
Mitigating risks from changing policy
Central banks must carefully navigate the implementation of changes to their frameworks. Poorly timed or inadequately communicated shifts in monetary policy could undermine credibility, especially in emerging markets and developing economies. Clear and internationally coordinated communication is essential to ensure that economic agents and financial markets understand the rationale for changes. Introducing the framework during periods of relative stability – when inflation is near target – can help build credibility and reduce the risk of de-anchoring agents’ inflation expectations.
Monetary policy alone, however, cannot resolve the complex challenges posed by climate-driven inflation. Fiscal policy must play a proactive role in building supply-side resilience, preventing and mitigating negative supply shocks.
The adaptive-IT proposal acknowledges the unique challenges of a hotter and more volatile world, and with it we call on central banks to discuss how to navigate persistent supply shocks while preserving their credibility. As central banks adapt to the realities of climate change and geoeconomic fragmentation, they have an opportunity not only to reevaluate their price stabilisation strategies but also to support the transition to a more resilient and sustainable global economy.
This commentary was first published by CETEx and is based on a new report, The Case for Adaptive Inflation Targeting: Monetary Policy in a Hot and Volatile World.
