How Persistent are Climate-Related Price Shocks? Implications for Monetary Policy

How Persistent are Climate-Related Price Shocks? Implications for Monetary Policy Alain Kabundi, Montfort Mlachila, and Jiaxiong Yao WP/22/207 IMF Working Papers describe research in progress by the authors and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. 2022 OCT We would like to thank, without implication Mokhtar Benlamine, Gaston Gelos, Stephane Hallegatte, Deniz Igan, Luis Brandao Marques, Maxwell Mkondiwa, Sampawende J. Tapsoba, and seminar participants at the IMF for their valuable comments. © 2022 International Monetary Fund WP/22/207 IMF Working Paper African and Monetary and Capital Markets Departments How Persistent are Climate-Related Price Shocks? Implications for Monetary Policy Prepared by Alain Kabundi, Montfort Mlachila, and Jiaxiong Yao* November 2022 IMF Working Papers describe research in progress by the authors and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. ABSTRACT: Climate change is likely to l ead to more frequent and more severe supply and demand shocks that will present a challenge to monetary policy formulation. The main objective of the paper is to investigate how climate shocks affect consumer prices i n a broad range of countries over a long period using local projection methods. It f inds that the impact of climate shocks on inflation depends on the type and intensity of shocks, country income level, and monetary policy regime. Specifically, droughts tend to have the highest overall positive impact on inflation, reflecting rising food prices. Interestingly, floods tend to have a dampening impact on inflation, pointing to the predominance of demand shocks in this case. Over the long run, the dominant monetary policy paradigm of flexible inflation targeting faced with supply-induced climate shocks may become increasingly ineffective, especially in LIDCs. More research is needed to find viable alternative monetary policy frameworks. RECOMMENDED CITATION: Kabundi, Alain, Montfort Mlachila, and Jiaxiong Yao. 2022. “How Persistent are Climate-Related Price Shocks? Implications for Monetary Policy,” IMF Working Paper 22/207. JEL Classification Numbers: E31, E50, E52, Q54 Keywords: climate change, monetary policy, monetary policy models Author’s E-Mail Address: akabundi@imf.org; mmlachila@imf.org; jyao@imf.org Contents 1. Introduction ..................................................................................................................................................... 3 2. Related Literature ............................................................................................................................................ 5 3. Data and Stylized Facts .................................................................................................................................. 7 3.1 Data Sources and Transformations .......................................................................................................... 7 Disasters .................................................................................................................................................. 7 Temperature and Precipitation Shocks ................................................................................................... 8 3.2 Stylized Facts ........................................................................................................................................... 9 4. Empirical Strategy ......................................................................................................................................... 14 4.1 Methodology ........................................................................................................................................... 14 4.2 Impact of Natural Disasters on Inflation ................................................................................................. 15 4.3 Impact of Climate Shocks on Inflation .................................................................................................... 24 Results ......................................................................................................................................................... 25 5. Conclusion ..................................................................................................................................................... 28 APPENDICES A. Natural Disasters and Food Inflation at the Subnational Level ............................................................... 30 B. Results with Additional Control Variables ................................................................................................. 37 C. The Role of Food In