{"id":69934,"date":"2024-02-14T11:06:02","date_gmt":"2024-02-14T11:06:02","guid":{"rendered":"https:\/\/www.lse.ac.uk\/granthaminstitute\/?post_type=news&p=69934"},"modified":"2024-08-16T10:21:53","modified_gmt":"2024-08-16T09:21:53","slug":"rethinking-inflation-in-times-of-environmental-instability","status":"publish","type":"news","link":"https:\/\/www.lse.ac.uk\/granthaminstitute\/news\/rethinking-inflation-in-times-of-environmental-instability\/","title":{"rendered":"Rethinking inflation in times of environmental instability"},"content":{"rendered":"\n

Inflation has cooled for the time being, but intensifying environmental shocks and geopolitical tensions could play an increasingly central role in driving price instabilities, calling for a rethink of inflation forecasting and monetary policy implementation, write David Barmes and Simon Dikau.<\/p>\n\n\n\n

Following the abatement of supply chain disruptions resulting from COVID-19 and the war in Ukraine, the bout of inflation experienced in the UK (and globally) over the past two years has relented<\/path><\/svg><\/a>. But such disruptions are expected to become more frequent in the context of intensifying climate change, environmental degradation and geopolitical tensions, marking a new era of supply-side uncertainty for which economic forecasting and policymaking are ill-prepared. The recent rise in shipping costs resulting from the Houthi attacks in the Red Sea and low water levels in the drought-stricken Panama Canal<\/path><\/svg><\/a> are just the latest examples of how geopolitical fragmentation and environmental instability can jeopardise global trade and economic output.<\/p>\n\n\n\n

‘Climateflation’, ‘fossilflation’ and ‘greenflation’<\/strong><\/h2>\n\n\n\n

Isabel Schnabel from the European Central Bank’s (ECB) Executive Board coined the terms<\/path><\/svg><\/a> ‘climateflation’, ‘fossilflation’ and ‘greenflation’ to describe the ways in which climate change, fossil fuels and a transition to renewable energy can generate inflationary pressures. ‘Fossilflation’ is not a new phenomenon, as volatile fossil fuel prices have long played a significant role in price instability given their<\/a> systemic significance<\/path><\/svg><\/a>. In 2022, 50% of year-on-year inflation in the eurozone was down to energy prices, with inflation rates across eurozone countries being heavily correlated<\/path><\/svg><\/a> with the energy intensities of their economies. In the UK, three-quarters<\/path><\/svg><\/a> of inflation at its peak came from the most energy-intensive components of the Consumer Price Index.<\/p>\n\n\n\n

Meanwhile, there is growing evidence that inflation is increasingly becoming an ecological phenomenon<\/path><\/svg><\/a>, particularly as natural disasters and other environmental shocks reduce agricultural output, thereby driving up food prices<\/path><\/svg><\/a>. This is what Schnabel calls ‘climateflation’, the effects of which are global in nature, as they transmit through trade links, and non-linear, meaning that they become far more pronounced as physical impacts worsen. ECB researchers<\/path><\/svg><\/a>, for example, found that 2022’s hot summer alone increased food inflation by 0.67 percentage points, and they project that higher temperatures will contribute 0.92–3.23 percentage points to food inflation annually by 2035 – conservative estimates by the authors’ own admission.<\/p>\n\n\n\n

As the academic evidence for the impact of climate change on food prices mounts, discrete cases of various other types of potential climate-induced inflation are materialising. For example, natural disasters are incapacitating energy infrastructure<\/path><\/svg><\/a> and scrambling global supply chains<\/path><\/svg><\/a>, disrupting highways, ports and railways. The inflationary effects of these negative supply-side shocks can be counteracted and even outweighed<\/path><\/svg><\/a> by the downward pressure on demand that can also result from the physical impacts of climate change. But monetary policymakers will not take much comfort in this, as recession and deflation are not desirable outcomes either, and this potential for opposing effects on prices implies greater unpredictability and volatility in price developments.<\/p>\n\n\n\n

To make matters worse, the burden of climateflation is felt disproportionately by those who have the least capacity to absorb it, worsening inequality on both domestic and international levels. On a domestic level, low-income households spend a bigger proportion<\/path><\/svg><\/a> of their income on food, making them more exposed to climate-induced food price inflation. On an international level, low-income countries that are particularly agriculture dependent, climate vulnerable, and have high shares of food in their consumption baskets are facing (and will continue to face) the most elevated and persistent<\/path><\/svg><\/a> climateflation, with wider macroeconomic repercussions that will exacerbate rising levels of debt distress in low-income countries.<\/p>\n\n\n\n

The broadest conclusion to draw from inflation becoming an increasingly ecological phenomenon is that price stability necessitates environmental stability, which requires economic policymakers to accelerate the transition to a sustainable economy. This pathway is not straightforward<\/path><\/svg><\/a> from a price stability perspective either, as environmental regulations, green investment booms and shortages in transition-critical material<\/a> could generate their own inflationary pressures (so-called ‘greenflation’). But anticipating and managing this type of inflation will be more feasible than achieving price stability in a scenario where the impact of a warming planet causes a mutually reinforcing downward spiral of both the supply and demand sides of the economy.<\/p>\n\n\n\n

Implications for central banks<\/strong><\/h2>\n\n\n\n

The growing ecological dimensions of inflation place understanding of the green transition at the very heart of central banks’ mandates. The ECB recently made a commitment<\/path><\/svg><\/a> to “consider climate change in the preparation of monetary policy decisions” – what might this look like in practice? Firstly, environmental science needs to be more deeply embedded in macroeconomic modelling and inflation forecasting. While limitations will inevitably persist, adopting a ‘suite-of-models’<\/path><\/svg><\/a> approach, including climate-specific models, would be a step towards improved inflation forecasting in an age of environmental instability. Secondly, central bankers will have to look beyond interest rate hikes as a price stabilisation tool or they will face repeated charges that they are feeding inequality<\/path><\/svg><\/a>, exacerbating debt distress<\/path><\/svg><\/a>, stalling the green transition<\/path><\/svg><\/a> and threatening financial stability<\/path><\/svg><\/a>, resulting in further deterioration of the public’s trust in central banks.<\/p>\n\n\n\n

Green targeted lending<\/path><\/svg><\/a> operations have been suggested by some<\/path><\/svg><\/a> as a potential start for a monetary policy strategy that supports a transition, and, in so doing, promotes price stability. The greening of collateral frameworks, particularly as pre-positioning<\/path><\/svg><\/a> of collateral becomes a more widespread practice, could be another priority for central banks. Going a step further, scholars and commentators have proposed various forms of direct green credit guidance<\/path><\/svg><\/a> or ‘mission-oriented’ financial regulation<\/path><\/svg><\/a> to manage demand and support environmental goals. However, whether central banks can and should consider it within their remit to ensure price stability by also more actively enabling a stability-enhancing green transition depends on signals from their government (for example, via remit letters), the interpretation of rules and conventions, and, importantly, whether environmental instability is recognised as an emergency.<\/p>\n\n\n\n

There is only so much we can and should expect from central banks, both in terms of achieving price stability and contributing to a transition via a greening of their operations. Fiscal and industrial authorities, which have the leading role to play in a transition, also have tools to address the sources and impacts of inflation, such as income and wealth taxation<\/path><\/svg><\/a>, various forms of price control, and antitrust laws. Therefore, a broader open question for central banks is how they can best foster<\/path><\/svg><\/a> the macrofinancial conditions that are needed for fiscal and industrial authorities to implement green industrial strategies and respond to inflationary pressures.<\/p>\n\n\n\n

In summary, intensifying environment-related supply-side shocks call for ecologically informed approaches to inflation forecasting and joined-up monetary, fiscal and industrial strategies that accelerate the transition to a sustainable economy while deploying a wide range of inflation control measures. As climateflation escalates, compounding the inflationary effects (including fossilflation) of rising geopolitical tensions, orthodox monetary policy may become increasingly untenable.<\/p>\n\n","protected":false},"excerpt":{"rendered":"\n

David Barmes and Simon Dikau explain why intensifying environmental shocks and geopolitical tensions could drive a rethink of inflation forecasting and economic policymaking.<\/p>\n\n","protected":false},"author":65,"featured_media":69935,"template":"","tags":[854,1158,4511,4606,839,1940,4607,4608,2326],"news-category":[16],"topic_area":[4694,4696,4712,4713],"class_list":["post-69934","news","type-news","status-publish","has-post-thumbnail","hentry","tag-adaptation-finance","tag-central-banks","tag-climate-related-financial-risks","tag-climateflation","tag-environmental-finance","tag-european-central-bank","tag-fossilflation","tag-greenflation","tag-inflation","news-category-20-commentary","topic_area-policy-evaluation","topic_area-uk-emissions-policy","topic_area-central-banks-and-other-financial-institutions","topic_area-global-financial-system"],"acf":{"exclude_from_sync":{"ref_value":"field_560538b0e7350","value":"1","type":false,"post_type":""},"show_translations_widget":{"ref_value":"field_6203d588c41e8","value":"0","type":false,"post_type":""},"downloads":{"ref_value":"field_52f16cc1a80f2","value":false,"type":"repeater","post_type":""},"rss_newsletter":{"ref_value":"field_54f5c2c1544d8","value":"","type":false,"post_type":""},"profile_link":{"ref_value":"field_52f164b5189e9","value":["david-barmes","simon-dikau"],"type":"relationship","post_type":"profile"},"article_link":{"ref_value":"field_52eee3c7f0586","value":"","type":false,"post_type":""},"article_link_title":{"ref_value":"field_5322399d89d42","value":"","type":false,"post_type":""},"spotlight":{"ref_value":"field_52f80896506d3","value":"","type":false,"post_type":""}},"yoast_head":"\nRethinking inflation in times of environmental instability - 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