GRACELIN BASKARAN: Climate change will heat up inflation

Central banks around the world are scrambling to implement measures to bring down inflation.

What was initially dubbed transient was then termed persistent. But high inflation is seemingly permanent — not because of high aggregate demand from stimulus or access to cheap credit, but because the prices of goods in our consumer price index (CPI) basket are on a one-way uphill climb due to the consequences of climate change.

High inflation is at the heart of nearly every government and central bank debate now. How to support growth while curbing inflation is on most policymakers’ minds. The European Central Bank and US Federal Reserve have scaled back their asset purchase programmes; many central banks — including those of the UK, Chile and Russia — have raised interest rates; and countries across the world have scaled back or eliminated their fiscal stimulus programmes.

But managing inflation will not only be a product of reducing fiscal stimulus or cutting interest rates to bring down aggregate demand. As we’ve seen around the world, climate change will inevitably translate to a steady increase for key goods in the CPI basket.

Let’s assess this in three areas: energy, supply chains and food. An increase in these costs, particularly energy and supply chains, will have knock-on effects for all parts of the CPI basket.

Over the last decade we have seen a sharp rise in particularly cold winters marked by deep freezes and snowstorms and in  exceptionally hot summers filled with wildfires and droughts. These climatic shocks have led to skyrocketing energy prices.

Let’s look at Texas, a hot southern state in the US. My childhood memories on the coast of Texas involve wearing a winter coat when the outside temperature was 20°C, because that was “cold” for the area.

In February 2021, Texas was hit by a power crisis after three severe winter storms that brought snow and subfreezing temperatures caused at least $20bn in damages, killed hundreds of people (the majority of whom died from hypothermia) and left over 10-million people without power.

Amid the storms, the Texas Public Utility Commission issued an order that wholesale electricity prices in the state should be set at $9,000/megawatt-hour (MWh). For comparison, Texas averaged $38/MWh in 2019 and $22/MWh in 2020. The order from the commission argued that astronomical prices were required because “energy prices should reflect scarcity of supply”. Texas ratepayers have now been hit with $38bn in excess energy costs that will have to be repaid over time.

Globally, high energy prices have been a key driver of current inflation. An exceptionally cold European winter and hot Asian summer put pressure on gas supply and led to gas prices increasing by 250% between January and November 2021.

A second key reason behind high inflation in 2021 was the disruption of global supply chains, as borders and ports suffered long backlogs, truck drivers and shipping containers remained in shortage and factories and warehouses struggled to restart production. These factors have driven up production costs, which have been passed on to customers.

Climate change will cause such disruptions to supply chains about the globe, permanently. In 2021, severe flooding in Vancouver, Canada, led to backups and delays at the Port of  Vancouver. Damage to two freight railways — Canadian National and Canadian Pacific — which carry about two-thirds of the cargo that arrives at the port, led to more than 80 vessels waiting for a slot to open up so they could be unloaded. This led to high costs and hefty delays.

Likewise, heavy rainfall and flooding in Europe in 2021 had huge consequences for supply chains. Cargo was unable to move in Germany, Belgium, parts of Switzerland, Luxembourg and the Netherlands due to damaged rail links. This had strong knock-on effects. German steel manufacturing giant Thyssenkrupp was unable to get raw materials due to the flooding, which had consequences for the automotive industry and domestic appliance manufacturing industry.

Finally, food prices will be driven up by climate change, which has the worst effect on the poor. In SA, a 1% increase in local food prices due to a weather shock can decrease the amount of food consumed by a household by 2.5%. By the second quarter of 2015, during one of SA’s worst droughts, grain and some crop prices had increased by 35% year on year. Take a minute to absorb what effect that would have had on household food consumption.

Going forward, central banks have a much larger challenge to contend with, beyond a Covid-19-triggered heating up of the economy. No part of the economy — or goods in the CPI basket — will be spared.

• Dr Baskaran (@gracebaskaran), a development economist, is a bye-fellow in economics at the University of Cambridge.