Economic Activity, Inflation, and Monetary Policy after Extreme Weather Events: ENSO and its Economic Impact on the Peruvian Economy

This paper studies how El Niño Costero, a large climatic event, generates physical risks disrupting business cycles and hindering the effectiveness of monetary policy. Using Peruvian data, we find consistent empirical evidence that El Niño shocks leave a footprint on the economy akin to a supply-side shock: it exerts inflationary pressures while simultaneously contracting GDP. The effects are very persistent and reflect the differentiated effects across sectors in the economy. Primary sectors response is more immediate and larger but only in the short term. Conversely, nonprimary sectors experience lagged effects that become considerably more persistent and important later on. We integrate these empirical findings into a semi-structural model that incorporates five non-linear transmission channels through which El Niño affects the economy. These non-linearities present a challenge for monetary policy design, as the economic uncertainty and the cost in stabilizing the economy depends on the frequency of El Ni˜no events. Faced with such large-scale shocks, hawkish conventional monetary policy remains a relevant, though limited, tool for stabilizing inflation dynamics.