An analysis of extreme weather events finds that droughts have lasting negative impacts on economic growth, and weather-related shocks generally increase inflation, but that these inflationary effects are usually temporary, according to new research from the Bank for International Settlements (BIS).
The global group of central bankers published a bulletin from its economists, which examined the economic fallout from extreme weather events, and the potential implications for monetary policy.
“Extreme weather events can impose high economic costs in the affected areas by reducing economic output and increasing prices, in addition to the social hardship they cause,” it said, adding that the frequency and intensity of these kinds of events, “have been rising and are likely to increase further.”
The research looked at the impact of extreme weather on eight major economies in the Americas region, noting that the effects of weather-related shocks are, “already tangible in the region.”
Specifically, it found that droughts reduce economic output for the two succeeding years, “due to lasting effects on agriculture, forestry and electricity production.”
Droughts can directly harm economic output by destroying farmland and disrupting labour supply, the report noted — but they can also have other effects, such as hampering hydroelectric power production and harming water transportation routes, which can raise costs and reduce output.
Inflation and monetary policy
As for inflation, the research found that, “while droughts and wildfires temporarily increase food prices and droughts and storms raise energy prices … in general there is no persistent impact on inflation.”
Ultimately, the paper concluded that the proper monetary policy response to these kinds of shocks depends on the type of event, and its likely impact on economic output and inflation.
Additionally, the paper noted that there can be secondary effects from extreme weather events for government finances, as these kinds of disasters, “can increase fiscal deficits and sovereign debt yields, affecting the fiscal space to react to future shocks.”
In terms of monetary policy, its use should depend on the scale of physical damage, the impact on supply and demand and the risk of secondary effects on inflation and inflation expectations, the paper said.
For instance, the research found that droughts increase both energy and food inflation, but that the impact is short-lived. Similarly, damaging storms tends to stoke energy inflation for a month after the initial shock, and wildfires produce a strong increase in food prices, but usually just for two to three months after the shock.
“Tightening monetary policy can be appropriate if the impact of an extreme weather event on inflation is expected to be more persistent. This is more likely to be the case if demand remains resilient … due to fiscal support or insurance payouts,” the paper said.
Conversely, central banks may want to consider loosening monetary policy when an extreme weather event destroys physical capital and is expected to harm output, but inflation expectations remain well anchored due to a lack of insurance or fiscal support, it noted.
In these circumstances, “central banks may want to look through inflation when commodity prices increase due to extreme weather events,” it said.