Climate-Driven Supply Shocks: QPM Tools for Central Banks in Developing Economies

The International Monetary Fund’s Institute for Capacity Development, in collaboration with research insights from the Bank of Uganda, Bank of Ghana, Reserve Bank of India, and National Bank of Rwanda, has produced a timely and policy-relevant working paper titled “QPM-Based Analysis of Weather Shocks and Monetary Policy in Developing Countries”. Authored by Valeriu Nalban and Luis-Felipe Zanna, the paper tackles the pressing challenge of how climate-induced disruptions, such as droughts and floods, complicate the monetary policy landscape in low-income and emerging market economies (LIDCs and EMs). At its core lies the Quarterly Projection Model (QPM), a semi-structural macroeconomic model designed to aid central banks in forecasting, scenario building, and policy decision-making. Through the integration of weather-related transmission mechanisms into the QPM, the paper builds a robust analytical framework that provides vital insights for monetary authorities in climates that are growing ever more unpredictable.

Weather Shocks as Persistent Supply-Side Disturbances

The paper establishes early on that weather-related shocks, particularly those that affect agricultural output, are predominantly supply-side in nature. When poor weather conditions damage crops, they reduce food supply, increase food prices, and subsequently raise headline inflation. This chain of effects is particularly potent in economies where agriculture holds a large share in GDP and where food comprises a significant portion of the CPI basket. The authors use their extended QPM to disaggregate both output and prices into agriculture vs. non-agriculture and food vs. non-food categories. These disaggregations enable a nuanced analysis of how adverse weather conditions ripple through to inflation expectations, monetary tightening, and output slowdowns. Their simulations show that the policy responses to such shocks often entail difficult trade-offs, especially in economies with weaker institutions, poor inflation targeting records, and limited fiscal buffers.

When Imports Deepen the Pain

A particularly novel element in the analysis is the role of food imports in buffering supply shortfalls. While importing food may help alleviate domestic shortages, the model reveals that this strategy introduces new vulnerabilities. Substituting damaged domestic crops with imports leads to a deterioration in the current account, puts downward pressure on foreign reserves, and raises the sovereign risk premium. This often results in currency depreciation, which further exacerbates inflation through imported goods prices. The simulations indicate that these macro-financial feedback loops can force central banks to hike interest rates even further than in cases of purely domestic shocks. As a result, dependence on imported food supplies during weather shocks can worsen overall economic volatility rather than ease it, particularly in countries with constrained access to foreign capital and limited central bank reserves.

Credibility as a Policy Lifeline

Central to the policy discussion in this paper is the role of monetary policy credibility and the anchoring of inflation expectations. In economies where central banks have a proven track record of achieving price stability, economic agents are more likely to trust that inflation will return to target after a shock. This trust, modeled in the QPM as a function of past inflation deviations, helps contain second-round effects and limits the need for aggressive monetary tightening. Conversely, in countries where credibility is weak, inflation expectations become more adaptive and more sensitive to recent shocks. The model simulates how credibility affects not only inflation outcomes but also the required scale of interest rate adjustments. Strengthening credibility, through transparent communication, consistency in actions, and institutional independence, can significantly soften the inflation-output trade-off that weather shocks often trigger.

The Power of Flexible Exchange Rates

Another critical insight is the stabilizing role of flexible exchange rates. Economies that allow their currencies to float have an automatic adjustment mechanism that absorbs part of the impact from external shocks. In contrast, pegged or tightly managed exchange rate regimes tend to push the full burden of adjustment onto interest rates. The simulations demonstrate that while fixed regimes may initially stabilize prices, they often result in sharper output contractions and greater inflation persistence if credibility is lacking. The model further explores the implications of choosing different inflation targets, headline CPI vs. core inflation. While targeting core inflation can reduce overreaction to food price spikes, this only works if the public trusts the monetary policy framework. A disconnect between official targets and perceived objectives risks undermining credibility, increasing volatility, and complicating central bank communication strategies.

Facing the Trade-Offs: A Call for Strategic Calibration

To capture the essence of the dilemma faced by central banks, the paper presents policy trade-off frontiers that plot inflation volatility against output and exchange rate volatility under different monetary rule calibrations. These visualizations illustrate that when weather shocks become more frequent or more severe, central banks face increasingly difficult choices. Prioritizing inflation control can lead to large swings in output and the exchange rate, while focusing on growth may undermine price stability. However, the model also shows that improvements in monetary policy credibility can restore more favorable trade-off conditions, even under heightened shock volatility. This underscores the importance of institution-building, transparency, and long-term consistency in policymaking.

The working paper provides not only a technically sound model but also a highly practical guide for policymakers in climate-vulnerable developing countries. By integrating weather-related shocks into QPMs, central banks are better equipped to simulate future scenarios, communicate policy responses, and make informed decisions amidst growing climatic uncertainty. The overarching message is clear: in a world of rising environmental volatility, economic resilience must be built not only through better forecasting models but also through stronger institutions, smarter policy design, and credible commitments to stability.