As extreme weather events rise in frequency and severity, record-breaking heat waves on land and in the ocean, drenching rains, severe floods, years-long droughts, extreme wildfires, and widespread flooding become more frequent and intense.

Extreme temperatures of 40+°C and even 50°C are becoming increasingly frequent worldwide. Natural climate variability, including the El Niño phenomenon, can result in extreme weather and climate impacts.

Still, climate change is leading to changes in the frequency, intensity, spatial extent, duration, and timing of weather and climate extremes. Sometimes, these impacts can be unprecedented.

The agricultural sector faces significant threats as extreme temperatures and erratic rainfall disrupt planting and harvest cycles, compromising crop yields and threatening global food security. Water management is challenged by the dual threats of floods and droughts, which compromise water quality and availability, stressing urban and rural water systems.

The health sector grapples with the direct impacts of heatwaves and pollution, which increase morbidity and strain healthcare systems, leading to heightened public health crises. Critical infrastructure, including energy, transportation, and housing, is often pushed beyond design limits by extreme events, necessitating frequent and costly repairs and upgrades.

The Reserve Bank of India in its April 2024 Monetary Policy Report noted that climate change in India “could impart upside risk to the domestic food inflation trajectory and could raise headline inflation by around 100 bps over the baseline.” These observations were primarily based on RBI’s 2023 report on Currency & Finance. According to this report, climate change impinges on monetary policy through three channels.

First are the direct inflationary pressures. Climate-induced disruptions in agriculture and global supply chains directly propel inflation. For instance, adverse weather events such as droughts and floods can hamper agricultural output, leading to increased food prices. Simultaneously, damage to infrastructure can disrupt supply chains, increasing production costs and consumer prices.

Second is the effects on the natural rate of interest. The natural interest rate could decline due to reduced productivity and economic output triggered by increased temperatures and more frequent extreme weather events. A lower natural interest rate complicates the central bank’s task of setting appropriate policy rates to manage economic activity effectively.

Third is the impaired policy transmission mechanisms. Climate-related economic uncertainties may undermine the effectiveness of monetary policy transmission. These uncertainties can affect the financial conditions of households and firms, making them less responsive to policy measures like interest rate adjustments.

Central banks are increasingly integrating climate-related risks into their analytical models to enhance the robustness of economic forecasting and policy interventions. For instance, a New-Keynesian model incorporating a physical climate risk damage function — calibrated using elements from the National Institute Global Econometric Model (NiGEM) — allows for a nuanced estimation of macroeconomic impacts under various climate scenarios.

Economic impact

The report further goes on to state, without substantial climate mitigation efforts, a modelled scenario predicts a long-term reduction in global economic output by approximately 9 per cent by 2050 relative to a scenario devoid of climate change. This scenario also suggests rising trends in both the level and volatility of inflation, driven by more frequent and severe climate shocks.

Such economic conditions may necessitate not only higher baseline interest rates to manage inflation but also greater responsiveness in monetary policy to address increased economic and financial instability.

A recent study by Kotz et al. (March 2024) published in Nature used fixed-effects regressions on over 27,000 monthly consumer price indices to assess the impact of climate change on inflation. Their research showed that higher temperatures consistently lead to higher food and overall inflation rates over 12 months, affecting both higher- and lower-income countries.

The severity of these effects varies by season and region, reflecting local climatic norms and extremes such as temperature variability and heavy precipitation. Projections for 2035 suggest a global annual increase in food inflation by 0.92 to 3.23 percentage points and headline inflation by 0.32 to 1.18 percentage points, depending on emission scenarios and climate models.

The impact is particularly pronounced at low latitudes and exhibits strong seasonality at high latitudes, peaking in summer. For example, the extreme heat during the summer of 2022 resulted in an increase in food inflation in Europe by 0.43 to 0.93 percentage points, a figure projected to rise by 30-50 per cent with anticipated warming by 2035.

Options for central banks

There are several options before central banks globally. First, monetary policy can directly support the transition to a green economy through instruments like green quantitative easing, which involves central banks purchasing green bonds to fund sustainable projects.

Additionally, adjusting collateral frameworks to favour green assets can incentivise financial institutions towards environmentally friendly investments. For instance, the ECB has adjusted its corporate bond purchases to favour entities with better climate performance metrics, while the Bank of Japan provides zero-interest loans for climate-related projects.

Second, central banks should develop methods to quantify climate impacts on economic entities through comprehensive stress tests. These tests are vital for understanding how climate scenarios affect millions of companies and banks, particularly through physical risks like heat waves or floods and transition risks from policy shifts.

For instance, the European Central Bank (ECB) has employed economy-wide stress tests to evaluate these impacts, projecting a substantial rise in default probabilities if mitigation policies are not enhanced.

Third, the financial stability framework must expand to address both physical and transitional climate risks. This includes the risk of financial instability triggered by sudden policy shifts or misaligned investments in green technologies. The risks associated with transition paths, such as policy misalignments or investment in non-viable technologies, can lead to significant economic and financial disturbances.

Finally, integrating climate change into monetary policy is about risk management and aligns with broader economic policies. For instance, policies aimed at reducing carbon emissions must be supported by monetary and financial regulatory frameworks to ensure they do not destabilise the economy.

This necessitates ongoing updates to policy models and assumptions based on the latest climate science and economic research.

The writer is Officer on Special Duty, Research, Economic Advisory Council to the Prime Minister. Views expressed are personal.