Climate Inflation is Coming. How Should Central Banks Respond?

The impacts of climate change are visible everywhere — wildfires in California, preseason hurricanes in the Caribbean, insufficient water in the Panama Canal, populations on the move everywhere from North Africa to Central America. Inflationary shocks are another looming worry. Food prices will become increasingly volatile, while property insurance rates will escalate — or insurance simply won’t be available. Labor costs will rise as employers spend to shield workers from hotter weather or raise wages where workers balk at heat exposure.

It all points not only to more inflation, but also to greater variation and less predictability across sectors and regions. In fact, that’s already happening. The figure below uses data from the Atlanta Fed to divide prices into half that are “sticky” in the sense that they rarely change and half that are “flexible,” meaning they go up or down with every bump to supply or demand. Since the late 1990s, the volatility of flexible prices has exceeded that of the “great inflation” of the 1970s. Even sticky prices are showing some ominous wiggles.

In the years ahead, more volatile inflation will make it harder for the world’s central banks, America’s own Federal Reserve Bank included, to meet their commitments to stabilize prices. Will they be up to the job? Not without some changes in strategy.

How Central Banks Fight Inflation

The most common strategy for stabilizing prices among central banks today is “inflation targeting.” The central bank of New Zealand was the first to try it back in 1990. Now it is the official policy of the U.S. Fed, the European Central Bank and many others.

The basic concept is simple. A central bank watches forecasts of inflation for the coming year. If the expected rate of inflation is higher than acceptable, the bank raises short-term interest rates. Those feed through to longer-term rates, which, in turn, slow business investment and consumer spending on homes, cars and other durable goods. If the forecast inflation rate is “too low” — we’ll get to what that means in a moment — the central bank cuts rates.

But policymakers must get the details right to make inflation targeting work well. Here are three not-so-fine points that will loom in a world of climate-driven volatility. 

Setting the right target rate. When you first think about it, you might suppose that if inflation is bad, the best target would be zero percent — no inflation at all. In the early days, some highly respected central bankers including Paul Volcker and Alan Greenspan did advocate a zero target. But today, major central banks set a target higher than zero, typically 2 percent, or a target range centered on a rate higher than zero.

One reason for adopting a non-zero target is the need for room to cut interest rates in recessions. In the U.S., for example, the Fed estimates that to stimulate the economy, it has to push interest rates below a “neutral rate” estimated to be about 0.6 percent higher than the prevailing rate of inflation. If inflation is currently 2 percent, for example, effective stimulus would require an interest rate lower than 2.6 percent. 

Two percent is not sacred. Roger Douglas, who was finance minister of New Zealand when that country first tried inflation targeting,is reported to have said, “I just announced it was gonna be 2 percent, and it sort of stuck.” 

The lowest possible setting lies in a range from 0 to 0.25 percent. A cut in the policy interest rate from a neutral 2.6 percent to 0.25 percent would provide a quite a bit of stimulus. However, if the initial inflation rate were zero, putting the neutral rate at 0.6 percent, there would be almost no room for stimulus. Any recession would be likely to last longer and the recovery from it would be slower.

A second reason for a positive target rate is to give more room for relative prices and wages to adjust on their own. Even when the economy is cruising along at full employment, differing trends in productivity, consumer tastes and world trade are always pushing some prices and wages up and others down.

Some welcome those relative changes and others resist them. The strongest pushback comes from workers in lagging sectors, who resist wage cuts. If they are unionized, they may strike. Even nonunion employers may find that their best workers quit in the face of wage cuts, while the demoralized remainder become less productive. Cutting prices in the face of falling demand is not resisted as tenaciously as cutting wages, but many firms succumb only under the extreme pressure of tanking sales.

A positive inflation target provides a cushion against these downward wage and price rigidities. A 2 percent inflation target would permit wage and price increases of 3 or 4 percent in leading sectors while still allowing increases of 1 percent, or at least no outright cuts, in lagging sectors.

But 2 percent is not sacred. Roger Douglas, who was finance minister of New Zealand when that country first tried inflation targeting, is reported to have said, “I just announced it was gonna be 2 percent, and it sort of stuck.” Today, many economists think a target higher than 2 percent would be appropriate, in part because it would give central banks more room to cut rates in future recessions. The prospect that climate change will increase price volatility only makes the logic of a higher target that much more persuasive. 

Targeting the right index. The next devilish detail is which of many inflation indexes to use as the target benchmark. In the U.S., the one that makes the headlines is the consumer price index, or CPI. The headline rate for the EU, the “harmonized index of consumer prices,” is slightly different. The Fed sets its target in terms of a third measure, the personal consumption expenditures index (PCE). Inflation benchmarked by the PCE tends to run about half a percentage point below the CPI.

But the PCE index is not the only measure of inflation that the Fed uses. It also pays close attention to “core inflation” — that is, PCE inflation calculated excluding food and energy. The thinking is that this core index gives a good picture of underlying inflation trends. 

Adapting inflation targeting to climate trends is likely to require raising the target rate itself, modifying the indexes used for short-term policy decisions and lengthening the period over which inflation is brought back to the long-term target after temporary shocks. 

Monetary policy can control overall inflation in the long run, but it can do little to affect relative price movements, such as isolated spikes in, say, beef or gasoline prices. Overreacting to such transitory shocks could easily backfire in a way that destabilized the economy.

Note that climate change could make current measures of core inflation obsolete. Rather than moving randomly up and down from a stable average, future food prices are likely to develop an upward trend relative to less climate-sensitive goods. The same could be true of energy prices. In that case, excluding food and energy from the target index would no longer make sense.

One remedy would be to switch short-term targeting to a “trimmed mean” index. Instead of arbitrarily treating food and energy as the transitory factors, trimmed mean indexes simply clip off whatever prices are in fact the most volatile in any given period. The Cleveland Fed already publishes a trimmed mean version of the CPI and the Dallas Fed publishes a trimmed mean PCE. 

And did I mention the multivariate core trend inflation index from the New York Fed? Maybe I shouldn’t, or you’ll stop reading…

Lengthening the time horizon. Central banks do not try to hold the rate of inflation at its target month by month. In fact, trying to control inflation over a very short time horizon would risk harm to the real economy by pressing too hard against price and wage rigidities. Accordingly, without locking themselves into a strict calendar interval, central bankers use language like “medium term” or “longer term” to suggest a time horizon of more than a year but no more than a few years. If climate change intensifies the volatility of inflation and turns previously transitory movements of food prices into long-term trends, there would be a case for lengthening the time horizon over which inflation is averaged out.

Taking all these adjustments together, then, adapting inflation targeting to climate trends is likely to require a combination of raising the target rate itself, modifying the indexes used for short-term policy decisions and lengthening the period over which inflation is brought back to the long-term target after temporary shocks.

Beyond Inflation Targeting

Inflation targeting, although common, is not universal. It is worth looking briefly at the problems faced by the central banks of a different group of countries — those that either have no separate currency of their own or maintain fixed exchange rates pegged to the value of another currency. Examples of countries with shared currencies include Ecuador and El Salvador, which use the U.S. dollar, and Montenegro and Kosovo, which use the euro but are not members of the Eurozone. Countries with fixed exchange rates include Saudi Arabia and several other Middle Eastern oil producers, which peg to the dollar, and several African countries, which peg to the euro. Finally, there is the special case of Eurozone members themselves, which do not have separate currencies but do have a vote in the policies of the ECB, which manages the euro. 

Any external shock to an economy, even a favorable one such as an increase in the global market price of a major export, creates a cascade of effects with both winners and losers. 

Economists have long studied the question of whether two or more countries are better off with shared or independent currencies. They agree on one point: currency areas work best when member countries are likely to be subject to similar economic shocks. For example, other things equal, two energy exporters might share a currency, but sharing would make less sense for an energy importer and an exporter. In many ways the same principle applies to the choice between fixed or floating exchange rates for countries with independent currencies.

Any external shock to a country’s economy, even a favorable one such as an increase in the global market price of a major export, creates a cascade of effects with both winners and losers. An export boom can push up input prices for producers in other sectors in the same country. A rise in import prices harms consumers but benefits producers of home-grown substitutes for imports. And so on.

When a country has its own currency, its central bank can mitigate the effects of such shocks. It can apply stimulus to avoid the pain of deflation, or control inflation by raising interest rates. A country that uses another’s currency has no such option. The central bank of Ecuador can do nothing to affect the exchange rate of the dollar, interest rates on U.S. government bonds or the quantity of dollars in circulation within its own borders.

Members of the Eurozone are a little better off, since each of them has a voice in decisions of the European Central Bank. But the ECB can’t — and certainly doesn’t — please everyone all the time. The Greek debt crisis that followed the global financial meltdown of 2007-8 is a case in point. The perceived interests of Germany and Greece diverged so sharply during that episode that Greece came close to leaving the Eurozone altogether.

Even countries that have their own currencies can get into trouble when they tie their exchange rates to other currencies. If the central bank of a fixed-rate country tries to stimulate its economy by cutting interest rates, it risks creating a run on its reserves of foreign currency. If its treasury tries to finance government spending by borrowing abroad, it can undermine investor confidence and risk a default on its debt. 

Here, Argentina is the poster child. To stop a hyperinflation in the early 1990s, Argentina pegged its currency firmly to the U.S. dollar. As far as inflation went, the policy worked. But it left the Argentine central bank unable to cope with a severe recession a decade later. In 2000, the country abandoned its currency peg and defaulted on its debt, leading to a severe crisis.

It is often a close call whether a country is better off within a currency area or outside it, or whether it would best have a fixed or floating exchange rate. An increase in the frequency and severity of relative price shocks driven by climate change could well tip the decision, causing some countries to consider moving away from shared currencies and fixed exchange rates toward floating rates.

Even the Eurozone is not immune. A 2013 retrospective on the effects of the global financial crisis concluded flatly that the Eurozone “does not currently represent an optimum currency area,” implying that the impact of economic shocks varied widely among members. The bloc survived, but in view of its diversity of climates, products and consumption patterns, it seems likely that climate change will pose an ongoing challenge to its survival.

The bottom line

Trends since the turn of the century and projections for the future make it clear that climate change will leave no part of the economy untouched. Central banks, like the rest of us, will have to deal with this reality. In particular, they will have to cope with the possibility of persistent upward pressure on the relative prices of climate-sensitive products such as food, as well as larger and more frequent shocks that can strike any sector of the economy.

Fortunately, central bankers are not without options. Inflation-targeting countries will have to rethink the 2 percent inflation goal that most of them have adopted, sometimes without much reflection. Going forward, 2 percent may not give enough room for stimulus in times of trouble. By the same token, policymakers may also want to reconsider which measures of inflation they use as benchmarks along with the time horizon they select for bringing inflation under control.

Central banks that impose fixed exchange rates already face constraints on inflation policy that make adjustment to shocks more difficult. We may see fewer countries opt for fixed exchange-rate pegs going forward. Countries in currency unions (like the Eurozone) and those that have adopted another country’s currency unilaterally face even tighter constraints. The Eurozone has brought considerable benefits by reducing trade barriers and facilitating capital flows among member countries, but past shocks have already pushed it to the limit. It is worth thinking in advance about who is better in the euro area and who is not, rather than waiting for the next crisis to force a choice at an inopportune moment.

Unfortunately, even the wisest policies will not entirely shield economies from coming climate impacts. Every shock will produce both winners and losers. The best course will be to maintain enough policy flexibility in advance to manage climate effects in ways that spread the pain in as balanced a way as possible.

Originally published by Milken Institute Review. Reposted with permission.