Climate change can hinder growth, destabilise prices and threaten financial stability. While there have been discussions and measures taken by central banks worldwide to minimise the impact of climate change on financial stability, inflation has emerged as an area of concern.

The Reserve Bank of India has identified climate change as a threat to price stability and financial resilience. In its April 2024 report, the RBI highlighted climate change as a supply-side shock contributing to persistent inflationary pressures, particularly from extreme weather and erratic rainfall, which could raise headline inflation by about 100 basis points.

The recent HSBC Purchasing Managers’ Index (PMI) survey showed that manufacturing activity fell to a three-month low of 57.5 in May 2024 from 58.8 in April 2024, partially due to heatwaves.

Typically, monetary policy aims to balance inflation and growth. However, climate change lends a sense of uncertainty to policymaking. Worsening climate can lead to supply chain disruptions, particularly in farming. Energy shocks can trigger inflationary supply-side pressures. Ignoring them can lead to contractionary policies that undermine growth. Both can pass through to core inflation, especially in emerging economies where food has a higher consumption weight. Persistently high food prices in India have forced the RBI to maintain high repo rates.

As climate change increases weather shocks, affecting food and commodity supplies, lessons from the commodity boom of the 2000s remain relevant. Central banks may need to proactively anchor inflation expectations from climate-induced commodity/food price shocks while avoiding excessive tightening that hurts growth if the impact is transient.

Confronting these multidimensional threats to price stability demands revaluating 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. Integrating climate variables such as temperature, precipitation, soil moisture and extreme weather events is crucial to capturing the impact of climate change. This approach can help the RBI better anticipate supply-side inflationary pressures from agricultural losses, energy demand fluctuations and disrupted production networks.

Strengthen monitoring

The RBI must strengthen its regulatory monitoring and surveillance mechanisms to keep a pulse on inflation risks across climate-vulnerable sectors such as agriculture, energy systems and transportation, which have substantial weightage in consumption baskets.

It should allocate dedicated resources to track indicators like crop conditions, water availability, energy demand fluctuations and supply chain resilience. This can inform timely policy interventions and facilitate contingency planning by detecting emerging climate-induced bottlenecks and price pressures early on.

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 not overreact to transient shocks, but communicate a measured policy response to anchor inflation expectations.

The mitigation and adaptation of climate change can reduce the impact of this risk on economic output and inflation. The RBI should advocate for more public investment in climate-resilient infrastructure and practices, particularly in agriculture and transportation, which can mitigate supply-side inflationary pressures. Complementary data infrastructure can further support evidence-based risk monitoring and policy design.

The most severe economic effects of climate change will likely unfold well beyond the current monetary policy horizon. The RBI’s inflation projections are currently for one year. Extending these projections gradually — possibly to 10 years — could better account for the effects of climate change on inflation.

Bank of England and European Central Bank have already started assessing the impact of integrating multi-decade climate pathways into their decision-making processes.

Reforming monetary tools through climate-integrated forecasting, prioritising sensitive industry monitoring and timescale calibration 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 established credibility and autonomy, the RBI is well-placed to shape an optimal response to these exigencies.

Saurabh is Sustainable Finance Specialist at Institute for Energy Economics and Financial Analysis, and Labanya is Programme Head, Centre for Sustainable Finance, Climate Policy Initiative. Views are personal

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