Climate Change Presents Challenges to Monetary Policy: RBI Report

The Reserve Bank of India (RBI) in a recent report has identified the increasing frequency of weather shocks due to climate change as a major challenge for monetary policy. The report, titled "Monetary Policy Report - April 2024," highlights the escalating global temperatures and the consequent rise in extreme weather events (EWE), which are exerting both economic and social pressures.

Climate change has amplified the occurrence and intensity of weather shocks, presenting multifaceted obstacles for monetary policymakers. The report underscores several channels through which climate change affects monetary policy dynamics.

Primarily, adverse weather events stemming from climate change directly impact inflation by disrupting agricultural production and global supply chains. This disruption leads to supply-side shocks, contributing to inflationary pressures within the economy.

The report titled, “Monetary Policy Report- April 2024,” highlights the escalating global temperatures and the consequent rise in extreme weather events which are exhilarating both economic and social pressures.

Secondly, climate change influences the natural rate of interest due to its adverse effects on productivity and potential output. Rising temperatures and the increased occurrence of EWE undermine productivity levels, thereby lowering the economy's overall output potential.

Moreover, the aftermath of climate change has the potential to weaken the transmission mechanism of monetary policy actions to households and firms. This disruption in the transmission channels complicates the central bank's efforts to manage financing conditions effectively.

Recognizing the gravity of these challenges, central banks worldwide are increasingly integrating climate risks into their analytical frameworks and policy decisions. Many are adopting sophisticated models that explicitly account for the macroeconomic implications of climate change.

For instance, the report mentions the utilization of a New-Keynesian model that incorporates a physical climate risk damage function calibrated with aspects of the National Institute Global Econometric Model (NiGEM). This model helps estimate the macroeconomic impact of climate change by comparing scenarios with and without climate mitigation policies.

Alarmingly, the report projects a stark picture of the future in the absence of substantial climate mitigation efforts. It suggests that by 2050, long-term output could be reduced by approximately 9% compared to a scenario without climate change, with significant implications for inflation and its volatility.

Furthermore, the report warns of potential inflation hysteresis and the consequent de-anchoring of inflation expectations, which could erode the central bank's credibility. This scenario would necessitate even higher interest rates to curb inflation, leading to greater output losses.

Failure to address these challenges adequately could exacerbate inflationary pressures, dampen economic growth, and undermine monetary policy effectiveness.