Monetary policy must account for climate risks as well

To begin with, the trade-off between inflation and growth will get much harder to manage

- Tulsi Jayakumar

As a debate intensifies over the Reserve Bank of India's (RBI) decision to keep its policy repo rate at 6.5% for the 10th consecutive time in its fourth bimonthly policy meeting for 2024-25, we must shift attention to a critical yet under-studied aspect: the implications of climate change for the central bank's conduct of monetary policy.

Climate change presents two major types of risk. The first are physical risks or tangible risks from gradual global warming, such as the effects of temperature and rainfall changes or extreme weather events like floods, droughts, and tsunamis. These events can severely damage infrastructure, disrupt global supply chains, and impact much else.

The second are transition risks, which arise as the economy shifts away from fossil fuels toward a low-carbon economy. This may involve carbon taxes, the adoption of renewable energy and carbon disclosure mandates, disproportionately affecting some industries and economies. Both physical and transition risks can lead to supply and demand shocks, impacting price stability through multiple channels, often with opposing effects.

On the supply side, physical climate risks can hit agricultural productivity and food security, as well as energy production and distribution, while also hurting capital stock and infrastructure—all of which can mean shortages and price volatility. Also vulnerable is labor productivity, while higher mortality may reduce labor supply. Short-term fluctuations in output can result in inflation and other forms of macroeconomic volatility.