Climate Change and Monetary Policy: Navigating Physical Risks

Climate change is becoming an increasingly important consideration for central banks because of its implications for economic stability, inflation, and output. In Canada, physical climate hazards such as wildfires, floods, and storms can destroy productive capacity, housing, and critical infrastructure while disrupting domestic and global supply chains. These shocks can reduce economic activity while simultaneously putting upward pressure on prices, creating challenging trade-offs for monetary policy. The challenge may be particularly acute in small open economies, where disaster impacts can also affect external demand and terms of trade. This note examines the implications of physical climate risks for monetary policy by reviewing evidence on how climate-related disasters affect output and inflation, with a focus on Canada, and by using a structural macroeconomic model to assess how more frequent and severe natural disasters could shape macroeconomic outcomes and the inflation-output trade-offs facing policymakers.