An unlikely intersection

In recent weeks, the US administration has acted in two areas that are considered by many investors as completely disconnected: the nomination of a new Fed Governor and the repeal of a key underpin to climate regulation.

The US administration has been clear over the past year in its desire for interest rates to be lower. This has led to a great deal of friction between the current Fed governor and President Trump. The question of central bank independence and optimal rates has been a topic of discussion on investor desks, news desks and economic policy wonk dinners the world over. 

Meanwhile, the administration’s decision to revoke the ‘endangerment finding’ – which had confirmed that GHG emissions harmed human health and should be regulated – is the latest in a series of steps to roll back US climate policy. It has caused consternation among climate scientists, sustainability professionals and climate policy wonks. 

These seemingly disconnected, high profile actions got me thinking. What if they are more connected than many investors realise?

We know that physical climate events – acute and chronic – can affect the supply and demand side of the economy through their processes of disruption and repair. As I highlighted recently, research from the University of Zurich found that these events have meaningful, non-uniform effects on US companies. 

The greater the climate change, the more severe and frequent these extreme weather events are. This makes what happens in the physical world potentially highly relevant to what happens in the monetary policy sphere. 

In this article, I outline the main transmission mechanisms for weather events to influence inflation and economic growth and build a framework for investors to identify central bank reaction function to extreme weather.   

The impact of extreme weather on inflation and growth

The Bank for International Settlements (BIS) published a comprehensive paper last year analysing the macroeconomic effects of extreme weather events across 151 countries between 2000 and 2024.

Three conclusions are particularly relevant for monetary policy:

1. Persistent output effects: Extreme weather events have had significant and lasting impacts on GDP, even after controlling for buffers like sovereign credit ratings and insurance coverage.
2. Short-term inflation effects: Weather events produce measurable, though typically temporary, increases in inflation — particularly in food and energy prices.
3. Conditional amplitude: The magnitude of these effects depends on the type and scale of the event, whether supply or demand channels dominate, and country-specific factors such as food sensitivity, fiscal capacity and insurance penetration.

The Central Banker’s Challenge

The implications of extreme weather for monetary policy depend on a combination of structural features, event-specific effects and long-term effects:

Structural Features

Central Bank Mandate – What is the central bank’s explicit mandate and where do other priorities lie? 

The scope of a central bank’s mandate shapes its response to extreme weather events. The Federal Reserve’s dual mandate requires balancing price stability and full employment, whereas the ECB prioritises price stability. Financial stability considerations also influence policy decisions for many central banks. These responsibilities may affect central bank response functions.

Geography – What direct and indirect climate risks does the country face? 

Countries face different direct and indirect climate risks. Large, diverse economies may confront varied regional shocks; smaller or geographically concentrated economies may be exposed to fewer but potentially more extreme events. Indirect exposure through global supply chains — particularly energy and food — also plays a critical role.

Source: Carbon Brief as of 18 November 2024

Economic Structure – What sectors are crucial drivers of economic activity? 

Sectoral composition matters. Agriculture is particularly vulnerable to extreme weather, which increases exposure to food inflation. Emerging and developing economies, where agriculture represents a larger share of output, are typically more exposed.

Buffer – To what extent are fiscal support and insurance coverage available to moderate the effects of a weather event?

The BIS research highlights that a country’s sovereign credit rating and insurance coverage moderate the effects of extreme weather events on the macroeconomy. For the most part, this highlights that developed countries should be better positioned than emerging markets to moderate the effects of extreme weather events. 

However, spiking residential insurance costs and even declining insurance availability in high risk areas in the United States highlights that developed countries are not immune.

(Side note: I do wonder whether, in certain circumstances, inflationary fiscal support in the wake of a major weather event could compound the challenge for central bankers of an already inflationary event.)

Event-Specific Effects

Economic Impact – Does the disaster primarily affect supply, demand or both sides of the economy? Is the effect persistent and does it affect expectations?

The inflationary impact of a weather event depends on whether and to what extent it affects supply and/or demand in the economy.

Source: NGFS (as of August 2024)

The type of disaster is critical for determining the scale and locus of the effect.

Source: BIS as of 2025

Research by the NGFS on the inflationary effects of disasters rightly makes the point: 

“The extent to which the damaged or destroyed capital stock is rebuilt is a key determinant of the long-term dynamics of the economy.”

Given inflation is at the core of central bank policy, it is worth highlighting that extreme weather events seem to affect food production most directly leading to food inflation. Energy also sees price effects from certain events (e.g. winter storms). 

Central bank governors may look through these effects if they are temporary and don’t bleed too much into headline inflation. Again, this will be disaster specific and conditioned by buffers, mandate and economic structure. 

Long-Term Dynamics

Output Effects – How much more frequent, severe and disruptive do weather events become and how do those effects compound for the economy?

It has often struck me that more frequent, destructive weather disasters has the potential to be stagflationary, raising prices and dampening output. The NGFS sounds the warning for policymakers acting in that context:

“Communication of monetary policy could be complicated, in particular for inflation-targeting central banks, when greater and persistent inflationary pressures from severe weather events call for policy tightening against the backdrop of an extensive decline in supply. 

Further out, policymakers have to wrestle with the question of the long-term implications of physical hazards for potential output and growth and the appropriate longer-run stance of monetary policy.”

Behavioural Effects – In the long run, how do more frequent, severe and disruptive events affect confidence, saving and investing dynamics?

It is reasonable to expect that individuals and businesses will respond to long term structural shifts in output because of volatile weather patterns. In so doing, these behaviours can affect the long-term neutral interest rate.  

Investor Implications

The evidence in this area is nascent and we need more research is needed especially as extreme weather becomes more prevalent. Nonetheless, here are the key takeaways for investors:

1. At the headline level, extreme weather events tend to be short-term inflationary and medium-term growth dampening.
2. Most of the inflationary effects of individual events are driven by food and energy prices as a result of supply-side effects, which central banks are inclined to look through. However, the scale, persistence and spillover of the output and price effect are key conditioning factors.
3. The precise impact of extreme weather for monetary policy is highly conditional on the type, scale and frequency of disasters. Droughts and landslides stand out for their persistent negative effects on growth while cold waves, storms and landslides have shown the most profound impacts on food price inflation.
4. Strong fiscal buffers, deep insurance markets and diversified economic structures can dampen macro effects, reducing pressure on monetary policymakers. Emerging market investors should be live to monetary policy pressures where buffers are low and geographic exposure to extremes is high.
5. Where disasters are frequent and/or severe enough to reduce potential output, the result could resemble a stagflationary shock of structurally lower growth with structurally higher prices. This would be a significant headache for monetary policymakers and investors to navigate.

As always, I welcome any questions or comments on this week’s article – email me at [email protected]. If you enjoyed this piece, you can subscribe for future editions using the button below.