The word “inflation” is becoming as ubiquitous as “Russia”, “Ukraine”, “energy” and “Covid-19” in newspaper headlines. But what if the worst — an exogenous, one-way-to-hell trajectory — is yet to come?
In an effort to combat this possibility, central banks are acting decisively. Last week the US Federal Reserve raised its benchmark interest rate by 75 basis points (bps), marking its biggest rate hike in 28 years.
To understand why this is problematic requires understanding the heart of the problem. Inflation generally stems from high demand amid low supply. We commonly see inflation when there’s a shortage of energy, food, housing, apparel or other staples.
The surge in US housing prices came on the back of lower interest rates and more money in people’s pockets due to fiscal stimulus. But housing prices are also being pushed up by a shortage of new housing stock.
During the boom of the 2000s the US built 2-million homes a year on average, and lumber prices generally stayed below $450 per 1,000 board feet (2.36m3). But amid droughts and wildfires the US is struggling to secure enough lumber to produce more than 1.3-million homes a year (a 40% decline). Lumber prices have more than tripled, crossing the $1,200 mark.
A similar dynamic can be found in food prices. It’s hard to argue against the fact that the Russia-Ukraine conflict has deepened food shortages. But after adjusting for inflation, 2021 food prices for the first 11 months of the year were the highest in 46 years. It’s evident that climate change was driving up inflation before the invasion took place.
We often see this as a government or central bank problem, but 2022 has shown that it’s most catastrophic for households
Generally, acute or shorter-term events such as floods, storms and droughts are viewed as a short-term pressure point. But if record-breaking compounding floods and droughts such as those seen recently in Western Europe and SA are anything to go by, we will see a short-term pressure point trigger medium-term inflation.
For example, new research shows that hot summers and droughts can have a direct effect on food prices beyond the short term. A panel regression of 48 countries showed that during a hot summer food prices increase by 0.38 percentage point and decline again about a year after the climate shock. This is more pronounced in developing countries.
Supply chain disruptions are also likely to trigger more medium-term challenges. In 2021 Brazil experienced its worst drought in 91 years and water levels in the Parana River, a key shipping route, dropped so low that cargo flow was disrupted. As we saw in Cape Town, restoring water levels takes more than a quarter — compounding droughts can drag the process out to years.
Central banks and governments worldwide have yet to fully contend with how to tackle the effects of climate change, from both a fiscal and monetary point of view. You can only raise interest rates so much before you stifle economic growth.
Severe effect
For example, businesses benefit from a lower interest rate environment as it encourages them to access the capital required for investment and expansion. This in turn can stimulate employment creation and generate much-needed tax revenue. Cheaper borrowing is particularly critical as more firms grapple with the effects of climate change, notably business disruptions.
For example, the heavy rainfall and flooding in Europe in 2021 had a severe effect on firms that relied on supplies that travelled by rail. German steel manufacturing giant Thyssenkrupp couldn’t access critical raw materials, which had domino consequences for the automotive and domestic appliance manufacturing industries. In some countries this can trigger retrenchments and a contraction in economic activity.
Macro-inflation loops can be economically devastating. We often see this as a government or central bank problem, but 2022 has shown that it’s most catastrophic for households.
Even if you didn’t understand what inflation was, it’s now a reality for every one of us at the grocery store, and hearts sink when we look at our monthly fuel bills. This leaves us with less money to spend on critical objectives such as education and health, not to mention more luxurious but economically important activities such as tourism and car purchases.
Governments and central banks, which are usually designed to be independent, and with good reason, may need to think carefully about complementary measures to manage the inflation and growth dimensions of climate change in the medium term and beyond.
Ample evidence shows that the current dilemmas are not purely because of war and a pandemic. Russian President Vladimir Putin is guilty of many sins but he did not slash US lumber production or increase the price of my morning coffee. Climate change did.
• Baskaran, a development economist, is a bye-fellow in economics at the University of Cambridge.
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