The Nexus of Climate and Monetary Policy: Evidence from the Middle East and Central Asia

This paper investigates the effects of climate shocks on inflation and monetary policy in the Middle East and Central Asia (ME&CA) region.
We first introduce a theoretical model to understand the impact of climate risks on headline and food inflation. In particular, the model shows how climate shocks could affect the path of policy rates through food prices.
We then use local projections to estimate the impact of climate shocks on headline and food inflation. The results show that price stability is more easily achievable under positive climate conditions.
Overall, our findings shed new light on the importance of considering climate-related supply shocks when designing monetary policy, particularly in countries where food makes up a significant part of the CPI-basket.

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The intersection of climate change and monetary policy presents a unique set of challenges and opportunities, especially for regions like the Middle East and Central Asia (MECA), which are particularly vulnerable to environmental shifts. Climate change exacerbates economic instability in these regions, where economies are often heavily dependent on natural resources such as oil, gas, and agriculture. Extreme weather events, changing precipitation patterns, and rising temperatures can disrupt production, increase inflationary pressures, and strain monetary policy frameworks that were designed for more stable, predictable conditions.
In the MECA region, where many countries are already facing economic volatility due to fluctuating oil prices, the compounded risks of climate change add an additional layer of uncertainty. For example, severe droughts can devastate agriculture, reducing food supplies and triggering inflation, while desertification and water scarcity can hinder industrial and agricultural productivity. These environmental stresses can put pressure on national currencies, increase government spending on climate adaptation, and alter inflation expectations, complicating the role of central banks.
Monetary authorities in this region are increasingly recognizing the need to incorporate climate risks into their policy-making. Climate-related financial risks-both physical risks from environmental events and transition risks from moving to greener energy sources-are starting to affect investments, the stability of financial institutions, and the overall cost of borrowing. Therefore, central banks must adapt their policy tools to account for these new realities. This might involve adjusting interest rates, revising inflation targets, and rethinking exchange rate management strategies to accommodate the economic fallout from climate events.
Furthermore, the MECA region faces a significant opportunity to leverage monetary policy to support climate change mitigation and adaptation efforts. Central banks and financial regulators can play a pivotal role in promoting sustainable finance by encouraging green investments, providing incentives for clean energy projects, and ensuring that financial markets price in climate risks. A well-designed green monetary policy could facilitate the transition to a low-carbon economy while fostering economic stability and sustainable growth.
Incorporating climate considerations into monetary policy frameworks is no longer a luxury but a necessity. As the MECA region continues to grapple with the consequences of climate change, the relationship between climate and monetary policy will become even more critical. Policymakers need to align their financial systems with climate goals to foster resilience, protect economies, and drive sustainable growth in the face of mounting environmental challenges.