Climate Change and the Potential Impact on Inflation | Lord Abbett
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Economic Insights

Did you know that climate change can have a big impact on monetary policy? As central banks around the globe focus on inflation targeting, the applications may be different in a carbon-constrained world.

Read time: 2 minutes

In our view, climate change poses a threat to monetary policy, but not just from the standpoint of big systemic risk shocks that we focus on today. Monetary policy must contend with a massive carbon transition, and also changes in relative prices. This means there will be new and less-understood shocks to inflation in the future. Right now, central banks are trying to amp up inflation via “flexible average inflation targeting,” where they allow inflation to run until it hits a certain average level. Given the arc of climate change ahead of us, we believe this type of targeting will merely be a placeholder for when central banks must again adapt to a changing world, likely via a nominal income target, because it can more safely operate alongside a carbon transition.

Potential changes in relative prices are easy to imagine. Electric vehicle use will drive down expenditures on gasoline, increasing the share of other categories like food. Droughts will increase the variability of food prices. Since inflation indices are usually constructed from expenditure shares this will change the nature of inflation shocks. Take, for example, weather events and the impact on crop prices, as illustrated below. Droughts have impacted international crop prices notably in recent memory, like in 2010-2011, and will certainly feature more frequently as global temperatures rise.

 

 

But are changes in relative prices a big deal for monetary policy? Relative price shares have been moving for decades – even if they move more rapidly with climate change mitigation efforts central banks really affect inflation through expectations. Policy could be successful in a climate change era by grounding expectations at target, but this is easier said than done, as inflation-targeting may not work in a carbon-constrained world, for two key reasons:

  1. The carbon transition plan: Not all remedies – carbon taxes, cap and trade systems, etc – for carbon emissions have the same effects. While some will provide predictable and stable outcomes, others will result in more volatility, which poses a problem for central bankers trying to forecast inflation.
  2. The response of prices to the transition: If there is a sustained rise in the price of carbon, this could become a feature of wage negotiations if workers believe their buying power is in decline. This is the risk of a wage-price spiral – last seen decades ago – that creates periods of high inflation. Alternatively, increasing carbon prices would mean a central bank raises rates to combat perceived inflation despite slowing economic growth.

Nominal income or price targeting has been proposed before, but it is usually rejected because we do not have enough accurate, real-time data on incomes or activity to make for good targets. But, in a future with both the Internet of Things and central bank digital currencies (CBDC’s), we believe central banks will finally have enough reliable data to follow such a rule.

 

The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Nominal income target refers to a monetary policy target as a means of managing economic activity.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein. If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research, or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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