Central Bank of Trinidad and Tobago working paper finds climate shocks raise inflation and improve inflation forecasts when climate variables are included

The Central Bank of Trinidad and Tobago published a research working paper assessing how climate change affects inflation dynamics and whether adding climate variables improves inflation forecasting. Using Trinidad and Tobago data, it concludes that climate-related variables have contributed to inflation momentum and that incorporating them can improve the Bank’s inflation forecasting framework. Using Vector Autoregression and Vector Error Correction Modelling over 1991 Q1 to 2022 Q4, the paper finds that temperature, precipitation, hot days, wet days and natural disasters raise food, core and headline inflation in the short run, while in the long run all variables except natural disasters continue to increase these inflation measures. Temperature shocks are also associated with a negative short-run effect on output. Forecast evaluation comparing a VAR with climate variables (VAR_C) to a baseline VAR over 2020 Q1 to 2022 Q4 shows lower error metrics for headline, food and core inflation when climate variables are included, alongside improved forecasts for some other endogenous variables such as government revenue and money supply. A separate ARIMAX scenario assuming a 1.5°C mean temperature change over 2023 to 2025 projects 370 climate-related disasters per year globally, 222 dryness occurrences and 15 flooding occurrences per year in Trinidad and Tobago, and annual increases in international meat and cereal prices of 2.5% and 9.0%, respectively. Under these assumptions, food inflation is projected to reach as high as 14.7%, core inflation around 3.2%, and headline inflation averages 6.0% over the forecast horizon.