When Climate Shocks Become Inflation Shocks: Rethinking Monetary Policy in Nepal

Inflation occurs from two different sources: demand side and supply side. When inflation is due to excess demand, raising interest rates can work as intended: higher borrowing costs moderate consumption and investment and help anchor inflation expectations. But when prices rise due to crops destroyed by flood or an erratic monsoon reducing agricultural supply, the same instrument operates through a different mechanism. It can restrain demand, but it cannot produce a delayed monsoon or make a damaged harvest reappear.

This distinction matters for Nepal as food accounts for a large share of household expenditure, and agriculture remains highly sensitive to climate shocks. The question is not whether the monetary policy should respond to climate-driven inflation, it must! The real issue is whether monetary tightening is an appropriate response to a supply shock, and what repercussions it has for households when it is used as the primary instrument.

The Problem of Food-Price Volatility

Conventional wisdom often treats agricultural supply shocks as temporary disturbances that eventually average out. But in low-income economies, inflation has historically been exposed to external and supply-side shocks. A 105 nations from 1970 to 2016 finds that global food and energy price shocks account for about 13% of the variation in core inflation in low-income countries-which is roughly half more than in advanced economies.

Climate change induced agricultural shocks sum up to this vulnerability in Nepal. Take recent weather patterns. Floods, droughts, erratic rainfall, and other extreme events can reduce agricultural output, damage infrastructure and disrupt market connectivity. The resulting increase in food prices doesn’t have to reflect excessive domestic demand: it can instead reflect a reduction in the capacity of economy to supply food. An IMF study finds that climate shocks (including floods, landslides, droughts and storms) have significant effects on food security, disproportionately affecting poorer and remote households.

An example of how climate shocks might reduce the capacity of economy to supply goods is the recent August 26 flood in Bhotekoshi. Roads, bridges, and other vital infrastructure along the Bhotekoshi-Trishuli corridor were devastated by the flash flood. Roads and bridges are not just physical infrastructure; they are crucial networks that connect producers, markets, and consumers; so such destruction has an economic impact. Transportation costs may increase and supplies may become limited in the short run when these links are broken (especially in remote areas). Thus, the resulting pressure on price is coming more from disturbance in the capacity of economy to supply goods, rather than an increase in domestic demand.

In the context of Nepal, where food occupies a massive share of household budgets. Nepal Living Standards Survey IV shows that in 2022/23 households spent 51.7% of total household expenditure on food. The share was approximately 59.4% for the poorest consumption quintile, compared with 43.6% for the richest quintile. When such a large share of a household’s budget is already committed to food, a price shock cannot be absorbed by simply cutting food consumption. The adjustment must occur somewhere else by reducing non-food consumption-like savings, borrowing or asset sales. 

The Double Burden

Climate shocks can therefore create a double burden on vulnerable households: an immediate loss of income or production, followed by reduction in the capacity to recover and prepare for future shocks. I call this the credit-resilience trap. First, the squeeze in investment. Let us assume a farmer whose crop has been damaged by a climate shock-recovery requires more than replacing the lost harvest. The farmer may need to invest in irrigation, improved seeds, storage, insurance or other adaptation strategies before the next shock-and much of this requires capital. If the inflationary consequences of the shock result in tighter financial conditions, the cost of borrowing can rise, precisely when investing in resilience is most important. In such a scenario, monetary tightening has the potential to create an unintended tension: the policies used to contain inflation may also make adaptation strategy more expensive. This does not mean that higher interest rates necessarily reduce adaptation investment in every scenario: it identifies a channel that deserves attention while climate shocks and monetary tightening occur together.

Second, the squeeze in consumption. Staple-food consumption is relatively difficult to reduce when prices rise (particularly for poorer households). An IMF study finds that, after floods, food prices in affected districts increased by around 4%, while food and non-food consumption fell by more than 6%. For poorer households, non-food consumption fell by as much as 15% as they were already close to subsistence levels of food consumption. The study also found that household assets fell by more than 3.5%, including through reduced investment in climate-resilient seeds and livestock sales. This distinction reveals something critical: climate shocks can raise food prices while simultaneously compressing real consumption and weakening balance sheets of households. If the resulting inflation is met primarily through tighter financial conditions, then these households may face a second constraint on top of the supply shock. 

The Identification Problem Comes First

Before designing policies, a fundamental empirical question must be tackled: how much can food inflation be attributed to climate shocks? Food prices are affected simultaneously by domestic demand, international commodity prices, exchange rates, transportation costs, agricultural production, government policies and expectations. So, the observation that food prices rise after a poor monsoon does not establish causality. Nepal’s geographic variation offers a promising avenue to address this problem. Different districts experience varying rainfall and temperature shocks, and have different levels of agricultural dependence, crop exposure, irrigation access, remoteness, and market connectivity. Exploiting this variation may help distinguish the climate-driven supply shocks from macroeconomic factors. An instrumental-variable strategy (especially using plausibly exogenous rainfall variation) could potentially strengthen identification, provided the relevance and exclusion restrictions can be defended. Rainfall should not be treated as a mechanically valid instrument as it can affect economic activity through channels beyond agricultural supply. A stronger design would be to combine climate variation with information on crop exposure, dependence on agriculture and connectivity to market.

This approach could also extend the question beyond inflation. An IMF study calibrating a spatial model to 51 districts in Nepal finds substantial geographic heterogeneity in the effects of climate shocks. Undernourished households experience roughly 50% larger welfare losses than the average household: while households in remote locations experience welfare losses roughly twice as large as those in less remote areas. So, the next question is not simply whether climate shocks raise food prices: but whether the same shock produces larger welfare effects in regions where households are more dependent on agriculture, have weaker market access, and spend a larger share of their income on food.

Structural Shocks Require Complementary Responses

Abandoning monetary policy when the prices of food rise isn’t the question as a temporary food shock can still become a broader inflation problem if it affects expectations, wages and other prices. Monetary policy may therefore need to respond when supply shocks become persistent or when they generate second-round effects. The point is simple: monetary policy cannot resolve the underlying supply constraint by itself, it requires a coordinated policy response. Food reserves and better market infrastructure can help to smooth temporary supply disruptions and improve the movement of food from surplus to deficit regions. Agricultural insurance based on climate change could provide farmers with liquidity after the shocks. Targeted adaptation finance could help maintain investment in irrigation, resilient seeds, storage and other adaptation measures even when broader financial conditions tighten. Longer-term investment in resilient agricultural and transport infrastructure could reduce the probability that localized climate shocks become severe and persistent food-price shocks.

These instruments operate on different time horizons. Monetary policy primarily impacts aggregate demand and inflation expectations, whereas, fiscal transfers can protect vulnerable households in the short run. Similarly, agricultural infrastructure and adaptation policies can strengthen supply and resilience over the medium and long run. The appropriate response is therefore not a choice between monetary and fiscal policy. It is a question of policy coordination according to the source, persistence and distributional consequences of the shock.

Conclusion

Central banks cannot control the weather. More importantly, they cannot use interest rates to repair a damaged harvest. As climate shocks become an increasingly important source of agricultural and food-price disruptions, policymakers need to distinguish between inflation generated by excess demand and inflation generated by supply constraints. The two may produce the same inflation number while requiring very different complementary policy responses. For Nepal, the challenge is therefore not simply to keep inflation low. It is to understand what is causing inflation, who is bearing its cost, and which policy instrument can address the underlying shock without making the next one harder to withstand. Monetary policy must do what it can. But when the shock begins in the fields, it cannot and should not be expected to produce a harvest.