Climate risks increasingly drive inflation, supply chain shocks

Bank of England's Swati Dhingra outlined three distinct channels through which climate change impacts inflation.

First, the economy's ongoing dependence on geopolitically exposed fossil fuels significantly affects headline inflation via direct energy components.

Energy price shocks have coincided with most UK inflationary episodes, contributing over three-quarters of inflation at the peak of the 2022–23 period.

Second, the physical impact of a changing climate, such as increasingly frequent extreme weather events, disrupts agricultural supply, pushing up food prices.

For instance, extreme summer heat in 2022 added an estimated 0.43–0.93 percentage points to Euro Area food inflation.

Third, the policy response to climate change, as decarbonisation measures can generate their own inflationary pressures.

Dhingra stressed that central banks' role is to maintain price stability in an economy increasingly affected by climate change and the green transition, not to deliver the transition itself.

These climate-related shocks are particularly challenging due to their salience for households and their increasing frequency and severity.

Global energy trade has reconfigured significantly since 2022, with US LNG becoming a major supplier to the EU and UK, highlighting ongoing fossil fuel supply chain disruptions.

Monetary policy's role is to prevent these relative-price adjustments from embedding in broader inflation dynamics through expectations and wages.

Physical climate shocks often affect inflation through food.

Extreme temperatures, droughts, and ENSO cycles reduce agricultural supply, leading to price spikes.

These effects are likely to intensify; Kotz et al. (2024) estimate higher average temperatures could add 0.32–1.18pp annually to global headline inflation by 2035 under a high-emissions scenario.

The current El Niño further raises risks for weather-sensitive crops.

Climate policy responses, like carbon taxes, have shown modest inflationary effects to date.

However, carbon prices would need to rise substantially for net zero, making transition policy more relevant for inflation over time.

This implies that while mitigation policies reduce long-run economic damage, they may raise near-term inflation and weigh on output, particularly if policies are not anticipated or lack credibility.