Towards a Climate-Conscious Monetary Policy Balancing Growth and Inflation

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Abstract
This paper investigates the impact of extreme climate shocks on the conduct of monetary policy in China. Leveraging annual prefecture-level city panel data and employing local projection methods, we find that such shocks consistently suppress economic growth and exert upward pressure on inflation. To uncover the underlying transmission mechanisms, we explore both supply- and demand-side channels, including short-term supply disruptions, persistent increases in energy prices, and long-term demand suppression. These dynamics suggest that extreme climate events generate acute policy trade-offs for central banks. Our further analyses reveal significant state-dependent in monetary policy responses: during expansions, climate shocks amplify deviations from inflation targets, whereas in recessions, output gap deviations dominate but with lower impacts. Stability phases show minimal policy deviations. Among various climate events, extreme rainfall causes the largest policy deviations. Moreover, we find that a flexible inflation targeting regime exhibits the greatest resilience, demonstrating the smallest climate-induced deviations across monetary policy frameworks. These findings underscore the critical importance of explicitly incorporating climate-related macroeconomic risks into the formulation and implementation of monetary policy.

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