Economic activity, inflation, and monetary policy after extreme weather events: ENSO and its economic impact on the Peruvian economy

This paper was produced as part of the BIS Consultative Council for the Americas (CCA) research network and conference on "Macro-financial implications of climate change and environmental degradation", held in Bogotá on 2-3 December 2024.

Summary

Focus

The El Niño-Southern Oscillation (ENSO) is a source of physical climate risk for several economies in the Americas near the Pacific Ocean. The Peruvian economy is particularly vulnerable to weather disruptions caused by El Niño Costero, a local version of ENSO. This large weather event causes natural disasters – such as droughts, floods and heatwaves – that alter business cycles and pose important challenges for monetary policy.

Contribution

The authors estimate the impact of large El Niño events on inflation, aggregate output and sectoral output using monthly Peruvian data from January 1994 to December 2019. They calibrate a semi-structural model that explicitly incorporates five non-linear mechanisms designed to replicate the empirical findings. Specifically, once El Niño Costero becomes a strong event, it triggers inflation pressures driven by higher food prices and a reduction in aggregate demand. As the El Niño escalates to a severe level, two additional channels are activated: a long-term GDP contraction and an increase in inflation expectations. If El Niño becomes persistent, then another channel comes into play: the central bank can lose credibility.

Findings

The authors find empirically that a large El Niño shock is a persistent supply-side shock: it induces inflationary pressures while GDP contracts. The effects are long-lasting and differ across different sectors. Primary sectors drive immediate and substantial economic contractions and increases in inflation, but only in the short term. In the medium term, the negative effects on non-primary sectors become more significant and persistent. The semi-structural model, with non-linear transmission channels, allows exploration of the implications of recurrent supply shocks. Faced with large-scale shocks, a hawkish monetary policy stance remains crucial to stabilise inflation dynamics, despite the relevant cost in economic activity resulting from such a policy stance. However, for more frequent and intense shocks over time, deviations in inflation from its target weaken the credibility of monetary authorities.

Abstract

This paper studies how El Niño Costero, a large climatic event, generates physical risks disrupting business cycles and hindering the effectiveness of monetary policy. Using Peruvian data, we find consistent empirical evidence that El Niño shocks leave a footprint on the economy akin to a supply-side shock: it exerts inflationary pressures while simultaneously contracting GDP. The effects are very persistent and reflect the differentiated effects across sectors in the economy. Primary sectors response is more immediate and larger but persistent. Conversely, non-primary sectors experience lagged effects that become considerably more persistent and important later on. We integrate these empirical findings into a semi-structural model that incorporates five non-linear transmission channels through which El Niño affects the economy. These non-linearities present a challenge for monetary policy design, as the economic uncertainty and the cost in stabilizing the economy depends on the frequency of El Niño events. Faced with such large-scale shocks, hawkish conventional monetary policy remains a relevant, though limited, tool for stabilizing inflation dynamics.

JEL classification: E31, E52, O44, Q54

Keywords: climate, extreme weather events, growth, inflation, financial and macroeconomic stability