Introduction

Climate change poses a significant threat to economic growth, price stability, and financial stability. As global discussions and measures continue to evolve, central banks, including the Reserve Bank of India (RBI), are increasingly recognizing the impact of climate change on inflation.

Climate Change: A Supply-Side Shock

• The RBI’s April 2024 report identified climate change as a critical threat to price stability and financial resilience.
• It highlighted that climate change acts as a Supply-side Shock, causing persistent inflationary pressures.
• Extreme weather and erratic rainfall can disrupt agricultural production and supply chains, contributing to a projected rise in headline inflation by about 100 basis points.
• Recent data from the HSBC Purchasing Managers’ Index (PMI) survey reflected these concerns, showing a drop in manufacturing activity to a three-month low of 57.5 in May 2024, partly due to heatwaves.

Balancing Inflation and Growth

• Monetary Policy typically aims to balance inflation and growth. However, climate change introduces significant uncertainty into policymaking.
• Worsening climate conditions can lead to supply chain disruptions, especially in agriculture, and trigger energy shocks that result in inflationary pressures.
• Ignoring these factors can lead to Contractionary Policies that undermine growth.
• This is particularly problematic in emerging economies like India, where food has a higher consumption weight, passing through to core inflation.
• Persistently high food prices have already forced the RBI to maintain high repo rates.
• As climate change exacerbates weather shocks, affecting food and commodity supplies, central banks must learn from past experiences, such as the commodity boom of the 2000s.
• They may need to proactively anchor inflation expectations from climate-induced commodity and food price shocks while avoiding excessive tightening if the impact is transient.

Rethinking Forecasting and Monitoring

• Confronting these multidimensional threats requires a reevaluation of how central banks approach forecasting, monitoring, policy implementation, and stakeholder coordination.
• Traditional inflation forecasting models focus on economic variables like output gaps, exchange rates, and energy prices.
• To better capture the impact of climate change, it is crucial to integrate climate variables such as temperature, precipitation, soil moisture, and extreme weather events.
• This approach can help the RBI better anticipate supply-side inflationary pressures from agricultural losses, energy demand fluctuations, and disrupted production networks.

Strengthening Regulatory Monitoring

• The RBI must strengthen its regulatory monitoring and surveillance mechanisms to track inflation risks across climate-vulnerable sectors such as agriculture, energy systems, and transportation.
• These sectors have substantial weightage in consumption baskets.
• By allocating dedicated resources to monitor indicators like crop conditions, water availability, energy demand fluctuations, and supply chain resilience, the RBI can inform timely policy interventions and facilitate contingency planning.
• Detecting emerging climate-induced bottlenecks and price pressures early on is crucial.
• The RBI should stick to a Headline Inflation target that better captures the household consumption basket rather than core inflation, as climate change can rapidly impact food production and energy prices.
• However, to preserve credibility, it should avoid overreacting to transient shocks and communicate a measured policy response to anchor inflation expectations.

Mitigation and Adaptation

• Mitigating and adapting to climate change can reduce its impact on economic output and inflation.
• The RBI should advocate for more public investment in climate-resilient infrastructure and practices, particularly in agriculture and transportation, to mitigate supply-side inflationary pressures.
• Complementary data infrastructure can further support evidence-based risk monitoring and policy design.

Extending the Policy Horizon

• The most severe economic effects of climate change will likely unfold beyond the current monetary policy horizon.
• While the RBI’s inflation projections currently span one year, extending these projections gradually, possibly to 10 years, could better account for the effects of climate change on inflation.
• Other central banks, such as the Bank of England and the European Central Bank, have already begun integrating multi-decade climate pathways into their decision-making processes.
• Reforming monetary tools through climate-integrated forecasting, prioritizing sensitive industry monitoring, and extending the policy timescale will be prudent.
• Engaging with the government on this issue would position the RBI at the forefront of evolving policy responses to climate change.
• With its established credibility and autonomy, the RBI is well-placed to shape an optimal response to these exigencies.

Conclusion

As climate change continues to pose significant challenges to price stability and economic growth, the RBI must adapt its policies and tools to effectively tackle climate change-induced inflation. By integrating climate variables into forecasting models, strengthening monitoring mechanisms, advocating for climate-resilient infrastructure, and extending the policy horizon, the RBI can better navigate the complex and evolving landscape of climate change and its impact on inflation.