The Federal Reserve Needs to Get Serious About Climate Change

People really hate inflation. Fortunately, prices are no longer rising nearly as rapidly as they were in 2021 and 2022. However, we may be on the cusp of a longer epoch of periodic inflation caused by climate change, one of the biggest long-term threats to price stability. The Federal Reserve should act accordingly.

America’s central bank has a dual mandate: It calibrates monetary policy to maximize employment while minimizing inflation. With unemployment reaching record lows, the Fed has been focused on controlling the spike in inflation we saw from 2021-2022. It quickly raised interest rates over the last two years in order to cool the economy and put downward pressure on prices. And voila, after peaking in the summer of 2022, inflation has steadily fallen to manageable levels.

However, the Fed’s rate hikes may not have been the primary driver behind disinflation. Inflation, it’s often said, occurs when there’s too much money chasing too few goods. The Fed’s higher-interest rate policy primarily hit the too much money side of the ledger, decreasing demand by making it more expensive for people and businesses to borrow. But there’s mounting evidence that the bigger macro-economic problem was too few goods. The Roosevelt Institute did a close analysis of inflation’s decline since 2022, and found that prices of goods have fallen even while demand has increased. That suggests that most of the decline in inflation has been from increased supply — that is, inflation was cured by recovering from pandemic-era supply chain bottlenecks. Supply chains that got snarled by COVID-19 production shutdowns and Russia’s invasion of Ukraine slowly sorted themselves out; as more goods came on to the market, prices eventually stabilized.

Indeed, the Federal Reserve’s own data found that supply chain pressure closely tracked inflation. Researchers at the San Francisco Fed found that supply chain issues account for 60 percent of inflation in 2021 and 2022.

In order to prevent future inflation flare-ups, we must guard against other foreseeable supply chain shocks. The pandemic may have been a once-in-a-lifetime (let’s hope) calamity, but it won’t be the last supply pileup. Climate change is also expected to wreak havoc on the global movement of goods. As the planet warms, droughts, floods, and other extreme weather will become more frequent and more severe. That will lead to a rise in the magnitude and frequency of supply-chain disruptions as factories are evacuated or shipping routes become untraversable.

For example, in August 2022, Chinese factories were closed not due to the pandemic, but because of a brutal drought. These closures in turn froze international supply chains for cars, electronics and other goods. Significant waterways for international trade, like the Panama Canal and the Rhine, have seen their water levels periodically dry up so much that shipping vessels cannot pass through, halting the shipment of goods.

We’ll see more of this as warming worsens. As the White House Council of Economic Advisers said, “As [supply-chain] networks become more connected, and climate change worsens, the frequency and size of supply-chain-related disasters rises.” The CEA found that over the last 40 years, the frequency of natural disasters around the world has tripled, and the number of billion-dollar disasters each year has risen from five to 20.

Food prices are among the most visible — and painful — forms of inflation for consumers. And we’ve seen climate-related weather events drive up food prices in the past. As the U.S. Department of Agriculture recalled in its 2022 supply chain report, a severe years-long drought in the southern plains states in the early 2010s dramatically culled the population of beef cows and caused historically high beef prices. And global heat waves in recent years have sent the cost of staple crops soaring.

While some amount of warming is locked in at this point, doing all we can to cut emissions as quickly as possible will help minimize future supply chain disruptions. That requires building massive amounts of new clean energy infrastructure. In 2022, the federal government passed major climate legislation as part of the Inflation Reduction Act to offer hundreds of billions of dollars in subsidies to encourage the development of wind farms, solar arrays, and other clean energy sources, as well as financial incentives for consumers to purchase electric vehicles, heat pumps, and other clean-energy home upgrades.

Unfortunately, the passage of the IRA has coincided with the Fed’s generationally-high interest rate policy. High interest rates have made it much more costly to build renewable energy projects in the U.S. and around the world — especially expensive projects like offshore wind farms, which have seen multiple cancellations and delays due to higher-than-anticipated financing costs. High rates are also a heavier drag on renewable energy projects than fossil fuel projects because the bulk of the costs for a wind or solar farm are in upfront construction.

The Fed expects to begin gradually cutting interest rates over the coming year if inflation continues to cool. That would ease borrowing costs throughout the economy, which will help more clean energy projects get built and make EVs more affordable to more buyers. That’s a win-win: A swift pivot to a clean-energy economy will reduce emissions, which will also mitigate future weather-related supply chain shocks. And that will make it easier for the Fed to fulfill its mandate to manage inflation in the future: Lower interest rates now will help support rapid decarbonization, which in turn will reduce climate-induced inflation down the road.

That’s not to say that the central bank needs to morph into a “Green Fed.”

“The Federal Reserve is not and will not be a ‘climate policymaker,’” Chairman Jerome Powell said in October, when the Fed and other agencies unveiled guidance for how banks should manage climate-related financial risk. “Decisions about policies to address climate change must be made by the elected branches of government.”

The Fed takes a thousand-foot view of the economy, and can’t set rates based on the needs of any one industry, no matter how important. But as climate change reshapes the world around us, all institutions will feel its effects, including the Fed. While environmental goals won’t drive Fed policy, managing long-term inflation will mean paying attention to how the bank’s actions affect the climate. Just as the Fed monitors how interest rate policy affects key sectors like the housing market, it should also pay increasing attention to how it affects the clean-energy sector.

When the Inflation Reduction Act passed, the law’s name drew some scorn as a supposed misnomer for what was fundamentally a climate bill. But over the long haul, combating climate change is a big part of what we need to do to ward off inflation. If we fall short, then missed decarbonization opportunities today will increase the threat of extreme-weather supply-chain bottlenecks tomorrow. And that means more inflation. Even if it’s not a “climate policymaker,” the Fed will come to care about climate change.The only question is whether that happens years from now, when climate inflation arrives in earnest, or now, when we still have a chance to do something about it.