Climate change and the transition to net zero are reshaping the macroeconomy, with important implications for monetary policymakers’ core price-stability objectives. As physical hazards become more frequent and severe, and as governments’ mitigation policies reallocate resources across the economy, central banks may increasingly face challenging trade-offs between stabilising inflation and supporting output. This column discusses the implications of climate change for monetary policy, including its effects on inflation, output, monetary transmission, structural economic factors and central bank communications. It introduces a practical framework for central banks as they assess, respond to, and communicate about climate-related shocks.

Energy and food prices are again at the centre of monetary policy debates (e.g. Bailey 2026). Recent shocks have demonstrated how supply-side disturbances can push inflation and output in opposite directions, leading to a trade-off for central banks between stabilising inflation and supporting output. Monetary policymakers must judge whether to ‘look through’ near-term inflationary pressures or tighten policy to reduce the risk that they become embedded in wage- and price-setting behaviour. As discussed in previous VoxEU columns (Erlandensen et al. 2025, Krebel et al. 2025), climate shocks often operate through similar supply-side channels. As these shocks become more frequent and severe (IPCC 2021), policymakers may need to manage trade-off-inducing shocks more often.

A new Network for Greening the Financial System (NGFS) report (NGFS 2026b) investigates the implications of climate change and the transition to net zero for monetary policy. The core message is that climate change will increasingly affect central banks’ core price-stability objectives. Although governments are responsible for setting climate policy, central banks will need to take account of the impact of climate change and the transition in their monetary policy decisions. 

Climate shocks can generate monetary policy trade-offs

Climate shocks can generate trade-offs for monetary policymakers between stabilising inflation and supporting output. Physical impacts, such as acute weather events and chronic shifts in climate patterns, can degrade productivity and disrupt supply chains, depressing output and leading to inflationary pressure. Transition impacts, arising from government policies like carbon pricing and green subsidies, or changes in consumers’ preferences, can also potentially generate monetary policy trade-offs, with resource reallocation affecting prices and output.

Ultimately, monetary policymakers should respond to climate shocks as they would to any shock: by assessing the implications for inflation and output over time. The key challenge is to judge whether a shock remains a relative price shock or evolves into broad-based inflationary pressure. A temporary rise in a narrow set of prices is not, by itself, a reason to tighten policy. But if the shock is more persistent and feeds through to broader inflationary pressures, it can become relevant for medium-term price stability. Several features can make climate shocks especially challenging for monetary policy: they can be large, long-lasting, spill over internationally, and affect prices that are salient for households – particularly food and energy. 

As physical climate shocks become more frequent, they may be harder to ‘look through’

The traditional prescription for a transitory supply shock is to ‘look through’ its first-round effects. Climate change may make that approach more difficult as physical shocks become more frequent and severe. A sequence of shocks that are individually transitory can interact and compound over time, leading to more persistent effects on inflation, output and expectations. Repeated shocks can erode fiscal space and resilience, while successive relative-price disturbances may increasingly spill over into wage and price-setting behaviour.

The NGFS report illustrates this using a scenario of repeated acute physical shocks, involving different combinations of heatwaves, droughts, floods and cyclones across various jurisdictions. Figure 1 presents the results of this exercise, with different physical shocks affecting each region over time. In general, GDP falls while inflation volatility increases, potentially generating trade-offs for monetary policymakers.

Figure 1 Repeated acute physical shocks can lead to trade-offs for monetary policymakers between stabilising inflation and supporting output

Notes: Modelled using NIESR’s NiGEM model. Effects of a global scenario combining the four acute shocks on key economic variables in select regions and aggregated at world level. Changes in inflation and policy rate shown in percentage points and changes in GDP in per cent, relative to a baseline scenario without acute shocks. In the scenario, central banks respond to deviations, relative to baseline, of headline inflation and the output gap, following the Taylor rule framework. The pattern of shocks differs between regions with the results reflecting international spillovers and potential amplifying / offsetting effects, with the strongest shocks in the El Niño years (assumed to be 2027 and 2030). See NGFS (2026b) for further detail on the modelled shocks.

The scale and persistence of macroeconomic effects depend on the type of hazard, the state and resilience of the affected economy and the effectiveness of government policy interventions. This is why physical hazards can lead to different policy choices across jurisdictions, as demonstrated by the case studies in Figure 2 and in line with the findings of Cantelmo et al. (2024) and NGFS (2026a). 

Figure 2 Case studies demonstrate that physical hazards can lead to different policy choices depending on the specific shock and jurisdiction affected 

Data source: NGFS (2026a).

Transition impacts critically depend on policy design 

Transition impacts arise from climate mitigation policies, technological innovation and changes in preferences. Carbon pricing, emissions trading schemes, green subsidies, regulation and carbon border taxes can all affect inflation and output.

The report models the impacts of illustrative Nationally Determined Contribution (NDC)-aligned transition policies across jurisdictions, set out in detail in NGFS (2026c). As shown in Figure 3, we find that carbon pricing can increase headline inflation and reduce output in the near term, especially in regions with higher dependence on fossil fuels. These inflationary pressures can coincide with weaker activity, creating a trade-off for monetary policymakers. 

The magnitude and persistence of these effects depend on the specific jurisdiction affected and the type, pace and credibility of mitigation policies. In an orderly and predictable transition where agents are forward-looking and inflation expectations remain anchored, inflationary effects are generally moderate in the model. But when policies are not fully anticipated or are less credible, inflationary effects are larger and more front-loaded, exacerbating trade-offs for monetary policymakers. Fiscal choices also matter: recycling carbon-tax revenues into green subsidies can offset some short-term impacts on inflation and output by supporting investment. Consistent with the NGFS scenarios, the modelling finds that near-term transition costs are outweighed over time by the benefits of avoiding more severe physical damages.

Figure 3 A carbon tax can push inflation up and output down in the near-term, generating a trade-off for monetary policymakers 

Notes: Modelled using the IMF’s Global Macroeconomic Model for the Energy Transition (GMMET). Results show the impact of an illustrative NDC-aligned carbon tax in each region. Impacts are modelled under the assumption of monetary policy “looking through” near term increases in headline inflation. The ‘looking through’ approach is implemented by a Taylor rule that targets core inflation which excludes energy prices and ignores measures that directly affect consumer prices, such as EV subsidies. See NGFS (2026c) for more details.

Climate change can lead to broader changes in the monetary policy environment

Climate change may also affect the monetary-policy environment more broadly by changing the structure of the economy and the channels through which monetary policy is transmitted. For example, physical shocks can reduce collateral values, tighten credit conditions, increase uncertainty and constrain intertemporal substitution, potentially weakening the effectiveness of monetary policy. Mitigation policies may widen differences between high- and low-emission sectors, leading to more heterogeneous responses to monetary policy. 

Climate change is also likely to affect the natural rate of interest,¹ r*. Physical hazards tend to put downward pressure on r* by dampening productivity growth, increasing precautionary saving and destroying capital. Further out, the impact on r* depends on how successful the transition is. In delayed or disorderly transition scenarios, weaker productivity, stranded assets and heightened precautionary saving may keep r* lower for longer. In more orderly transitions, r* can recover as productive green investment, capital reallocation, innovation and, in some cases, higher public borrowing support equilibrium real rates. 

The implications of climate-related uncertainty for monetary policy depend on the nature of that uncertainty. Greater uncertainty about inflation persistence may strengthen the case for a more forceful response. By contrast, uncertainty about the monetary transmission mechanism may favour a more cautious approach. Where policymakers are particularly concerned about highly costly outcomes, robust-control methods may be appropriate, where more weight is placed on avoiding these outcomes. 

A practical framework for monetary policymakers as they respond to climate change

Recognising the complexity of the implications of climate change for monetary policymakers, the report sets out a five-step process to guide central banks as they respond to climate-related shocks: identify the shock; assess its propagation; assess whether a monetary policy trade-off arises; set monetary policy and communicate the decision; and monitor and reassess.

For example, in the case of a localised flood (Figure 4), this would involve assessing the expected magnitude and persistence of the event and the sectors directly affected. Policymakers would need to consider the scope for the shock to propagate to the rest of the economy and whether first-round impacts on prices are likely to develop into more persistent second-round effects. The appropriate policy response will also depend on the wider context, including the central bank’s remit, the position of the economy in the business cycle, the scale and design of any fiscal response, the extent of insurance coverage, and the financial resilience of households, firms and financial institutions.

Forecasting these impacts is challenging in practice. Monetary policymakers will need to continue to monitor and reassess the impacts of the shock, and their policy decisions, over time, adjusting their stance as necessary. 

Clear communication can help anchor expectations and preserve credibility as central banks respond to climate change and the transition. For example, monetary policymakers could communicate their role in relation to climate change and the transition, given their objectives and mandate. They could acknowledge uncertainty, explain the broad factors that will determine their response to climate-related shocks, and tailor messages to different stakeholders. 

Figure 4 A step-by-step process for responding to climate-related events

Conclusion

As physical hazards intensify and transition policies reshape the economy, central banks may increasingly face monetary policy trade-offs. The key challenge is to distinguish shocks that primarily affect relative prices from those that threaten the medium-term inflation outlook, and to assess broader effects on output, monetary transmission, uncertainty and structural factors like r*. As climate-related shocks become more frequent and severe, those judgements will become more important for monetary policymakers. Climate change is therefore one of several evolving supply-side risks that central banks need to understand, monitor and assess for materiality. The NGFS report can support central banks as they diagnose climate-related shocks, assess the trade-offs they generate and respond in line with their mandates.

Source : VOXeu