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.