Extreme heat and inflation

As the climate changes, we are likely to experience more and more days with extreme temperatures. Most of the time, the impact of droughts or heatwaves will be local, but what if major waterways like the Panama Canal or the River Rhine have to shut down due to low water levels? In that case, global supply chains get disrupted and that, as we learned in recent years, can have a significant impact on inflation.

Serhan Cevik and Gyowon Gwon from the IMF tried to model the impact extreme temperatures have on supply chains and inflation in six large economies (USA, UK, Eurozone, China, Japan, and Korea). Based on the economic impact of past episodes of extreme temperatures, they showed that for most economies supply chain pressures from extreme temperatures are minimal. The chart below shows the response of the local supply chain pressure index (SCPI) to temperature shocks. The dark blue line is the median impact, while the light blue area shows a 68% confidence interval.

Temperature shocks and supply chain pressures

Source: Cevik and Gwon (2024)

Only in the US can we find some material impact on supply chains from extreme temperatures. This is likely due to the importance of inland waterways like the Mississippi and the Great Lakes as well as the importance of the Panama Canal for US supply chains. Similarly, China shows a little bit of supply chain reaction to temperature extremes due to the importance of local waterways for inland supply chains.  But overall, the results are so small that we can safely ignore the influence of global temperature extremes on supply chains.

Which does not mean that we can ignore their influence on the economy overall. The second chart shows the impact of extreme temperatures on headline inflation. Here we see – and this may surprise some readers – that extreme temperatures reduce inflation.

Temperature shocks and inflation pressures

Source: Cevik and Gwon (2024)

There are several reasons why high temperatures may lead to lower inflation pressures:

• Higher temperatures in winter reduce the need for energy to heat our homes. Yes, higher temperatures in summer increase our need to cool our homes, but as a rule, the reduction of energy demand in winter is stronger than the increase in energy demand in summer (partly because houses in Europe, the UK, China, and Japan don’t have air conditioning).

• In areas with moderate temperatures, higher temperatures prolong the growing season and increase agricultural yield, thus increasing supply and lowering food prices. This is less the case in the US, where high temperatures lead to water scarcity in major agricultural centres like California (nuts, fruit, citrus) and Florida (fruit, citrus).

• Higher temperatures reduce the output of the economy because people cannot work outside (or have to take more breaks), which affects output for construction and other sectors, plus people tend to be less productive in the heat because it is harder to concentrate. This, in turn, means economic output drops in high temperatures, and thus demand and inflation drop as well.

All of this simply shows one thing. Higher temperatures tend to be bad for the economy. And the only benefit we have from that is lower inflation pressures. But I am not sure if I want to heat the planet just to get inflation under control. That would be a little bit like undergoing chemotherapy just because you don’t want to shave in the morning.