The case for adaptive inflation targeting: monetary policy in a hot and volatile world

Negative supply shocks caused by climate change and interconnected crises may increasingly fuel persistent inflationary pressures. Responding to these shocks with standard monetary tightening would involve significant trade-offs, including impacts on economic output, financial stability, fiscal space, income equality and the green transition. While flexible inflation-targeting (FIT) regimes have faced supply shocks in the past, central banks may encounter new challenges in assessing and responding to these trade-offs, particularly when it comes to long-term macroeconomic stability.

Consequently, this report proposes the case for adaptive inflation targeting (or ‘adaptive-IT’), which aims to equip central banks with a framework, analysis and toolkit that enables them to better navigate these supply-side disruptions.

The report reviews existing literature on climate change and price stability, considers the risk posed by more persistent climate-related inflationary pressure and explores the trade-offs, challenges and implications for monetary policy. It proposes a shift from flexible inflation targeting to adaptive inflation targeting. This would prepare central banks to navigate supply-side headwinds while enabling fiscal policymakers to take a proactive role in preventing and mitigating negative supply shocks.

Main messages

• Physical hazards from climate change are already generating short-term inflationary pressures through their negative impacts on the supply side of the economy, especially on food prices.
• A series of persistent negative supply shocks would present a new conundrum for central banks: the expected policy reaction could exacerbate sacrifice ratios, intensify macroeconomic vulnerabilities and delay the transition to carbon neutrality.
• To avoid exacerbating the damage caused by climate-related supply shocks, monetary policymakers will have to consider, define and eventually adopt more adaptive monetary frameworks that clarify the importance of longer-term and climate-related supply conditions.
• Building on existing discussions, proposals and frameworks that revisit key features of flexible inflation targeting, the authors propose an adaptive inflation-targeting framework. The framework enables the explicit accommodation of higher inflation over longer horizons when supply conditions are systematically pushing up costs, giving central banks the latitude to exercise patience and appropriate discretion before resorting to monetary tightening.  
• Adaptive inflation targeting should be introduced in times of relative stability, when inflation is at or near the 2% target. Implementing such changes amid rising inflationary pressures could undermine central bank credibility and risk de-anchoring inflation expectations, particularly in emerging market and developing economies.

Key differences between flexible and adaptive inflation targeting