Issue 2: Climate Risk + Economic Policy Uncertainty → Economic Stagnation
Welcome back to Fed Lit, our monthly newsletter profiling essential climate literature for Federal Reserve staff, leadership, and all other interested parties.
“The Effects of Climate Risks on Economic Activity in a Panel of US States: The Role of Uncertainty” By Xin Sheng, Rangan Gupta, and Oğuzhan Çepni
Our focus paper this month models the impact of temperature increases and temperature volatility on economic activity in various states using monthly data from 1984 to 2019. This state-based approach adds to existing studies that focus on aggregate national- and international-level data, and supports the hypothesis that greater temperature increases and greater temperature volatility, which the authors shorthand as “climate risk,” lead to declines in economic activity.
Even more additive to understanding effects on economic stagnation is the authors’ consideration of the role of economic policy uncertainty in exacerbating the adverse economic impacts of increased climate risk. That’s especially relevant now, as consumers, households, and firms contend with extreme economic policy uncertainty. At the same time, mass terminations of National Weather Service employees threaten the federal weather data sources we rely on to assess climate risk. As we’ll see, the compounding effects of unpredictable temperature fluctuations and unpredictable economic policy raise concerns regarding effects on state-level economic activity.
Key Findings:
Climate risk, measured by temperature increases and temperature volatility, had a statistically significant negative impact on the state-level Coincident Economic Activity Index (CI). This index tracks nonfarm payroll employment, unemployment, average hours worked in manufacturing, wages, and salaries.
Increased state economic policy uncertainty (SEPU)—measured using an index that tracks state and local media coverage of economic policy uncertainty—had a significant compounding effect on climate risk, increasing the negative shock to the Coincident Economic Activity Indicator twofold when combined with a temperature increase in states with high levels of uncertainty.
State economic policy uncertainty had the largest negative impact on the Coincident Economic Activity Indicator when combined with climate risk emanating from temperature volatility. States with enhanced levels of policy uncertainty and increased temperature volatility experienced a 10 times greater impact to the Coincident Economic Activity Indicator when compared to states that did not experience enhanced levels of policy uncertainty.
Why It Matters:
Temperature volatility and economic and policy uncertainty are a dangerous combination when it comes to dampening economic activity. As this administration doubles down on decisions that produce temperature volatility, as it unleashes high levels of unpredictable economic policy choices, and as it limits or stops data production related to temperature changes, economic stagnation could worsen.
The authors demonstrate that the negative shock to economic activity does not dissipate quickly; over the 24-month period of observation following the shock, drag on economic activity is sustained.
State-level analysis allows us to understand stagnation effects state by state. While this model does not include federal policy drivers of uncertainty, it provides insight into how federal policy related to fossil fuel–driven temperature increases, temperature volatility, and data availability could create economic stagnation in states.
Is This Fed Business?
As the literature increasingly supports, and as Issue #1 described, climate change increases the inflation rate. This means that the Fed should be cautious when employing contractionary monetary policy to mitigate what could be climate-driven, as opposed to aggregate demand–driven, price increases. Today’s paper shows that the same climate shocks driving inflation can also drive economic stagnation in states, making contractionary monetary policy especially damaging to states that are experiencing slow growth.
The findings of this paper suggest that regional Federal Reserve Banks should monitor the effects of economic policy uncertainty on temperature-driven and temperature volatility–driven climate risk when assessing economic growth in the states that their regions comprise. Federal Reserve Bank presidents who are voting members of the Federal Open Market Committee (FOMC) should consider the effects of this policy uncertainty on economic growth, particularly when making decisions regarding the appropriate settings of monetary policy. Presidents of the Federal Reserve Banks should attempt to describe such economic policy uncertainty, particularly in order to (i) determine appropriate monetary policy in meeting the scale of climate shocks and (ii) ascertain ways in which FOMC statements can minimize policy uncertainty itself.
A Closer Look at the Research
The authors build on the foundation of empirical literature that demonstrates that climate risk—measured in terms of temperature increase and temperature volatility—negatively impacts economic growth. The hypothesis is that climate risk reduces labor productivity, erodes capital quality, and slows firm investment in research and development, disrupting both supply- and demand-side drivers of growth. Testing this hypothesis at the state level creates a fuller picture and permits a disaggregation of similar national and international studies. The state-level results are consistent with this hypothesis.
The piece of this analysis that has more value-add is its findings on the interaction of climate risk and economic policy uncertainty. Here the authors draw from Ben Bernanke’s 1983 article “Irreversibility, Uncertainty, and Cyclical Investment,” where the former chair articulates “real option theory”—the idea that uncertainty affects decision-making by raising the value of waiting for more information. Waiting for more information depresses aggregate demand by firms’ postponement of hiring and investment and depressed household consumption decisions until the heightened uncertainty passes. Sheng, Gupta, and Çepni also describe how uncertainty can halt normal “productivity enhancing reallocation”: Under normal conditions, less productive firms will contract and more productive firms will grow; these adjustments tend to maximize overall productivity and output, creating supply-driven growth. Under uncertainty, real option theory suggests that demand activities are compromised, and productivity enhancing reallocation suggests that supply activities are compromised.
To measure uncertainty, the authors employ an index created by surveying over 200 million state and local news articles from 1989 to 2019 for keywords related to economic policy and uncertainty within various states. This method provides a proxy for public sentiment about the state of the economy.
Relevant charts from the paper are duplicated and described here:
Figure 3. The US State-Level Nonlinear Effect of Temperature Growth (TGrowth) on the Coincident Indicator (CI) Contingent on Regimes of the SEPU
Using the index tracking state economic policy uncertainty (SEPU), the authors group high-uncertainty and low-uncertainty states and test the effects on economic activity of a one-unit increase in temperature growth. In the paper’s Figure 3, we can see that over the 24 months following a temperature growth shock, the model reveals an initial negative impact on the Coincident Economic State Indicator of ~1.25 units in the low-uncertainty states and ~2.5 units in the high-uncertainty states. This suggests that compounding uncertainty increased the magnitude of the negative economic effects by a factor of two.
In their next experiment, the authors test a one-unit increase in the volatility of temperature fluctuations and find much larger discrepancies in economic growth in high-uncertainty states as compared to low-uncertainty states.
Figure 4. The US State-Level Nonlinear Effect of SV of Temperature Growth (TGrowth_SV) on the Coincident Indicator (CI) Contingent on Regimes of the SEPU
In Figure 4, we can see that temperature volatility in low-uncertainty states had a comparable impact on economic growth as did temperature growth, yielding a ~1.25 unit decrease in the economic indicator. But temperature volatility in high-uncertainty states yields a ~15 unit decrease, over 10 times larger in magnitude than low-uncertainty states.
There is intuitive logic here, as temperature volatility can be interpreted as a form of climate risk uncertainty, contrasted with temperature increases, which reflect a marginal, predictable increase in climate risk. When uncertain climate outcomes and uncertain economic policy outcomes interact, the result is greater economic stagnation. As Federal Reserve System policymakers attempt to understand the effects of economic policy uncertainty, they should also incorporate uncertainty regarding temperature increases, temperature volatility, and perhaps even data availability when calibrating appropriate monetary policy settings. As climate risks grow—as measured by increases in temperature and increases in temperature volatility—and as the national policy environments continue to be chaotic and create uncertainty, this paper goes far in convincing us that understanding these two variables—climate risk and economic policy uncertainty—will be critical to mitigating economic stagnation.
To cite this paper:
Xin Sheng, Rangan Gupta, Oğuzhan Çepni. 2022. “The Effects of Climate Risks on Economic Activity in a Panel of US States: The Role of Uncertainty.” Economics Letters 213 (April). https://doi.org/10.1016/j.econlet.2022.110374.