IDB Tool Helps Measure Environmental Shocks and Inflation Dynamics in Ecuador and Beyond

Environmental shocks are ever more critical to monetary policy. Extreme weather events can disrupt agricultural production and supply chains and create price pressures that may extend beyond directly affected areas. These risks are particularly relevant for central banks in economies, like that of Ecuador, where food prices account for a significant share of household consumption and where the tools available to respond to supply-driven inflation may be limited.

An Essential IDB Database

With this in mind, the Inter-American Development Bank (IDB) Research Department developed a database of historical and forecasted environmental variables including precipitation, temperature, and agricultural variables describing crop allocation. Created through technical cooperation with central banks, the database gives central banks in the region the building blocks to research how environmental risks affect monetary policy and financial stability.

The Central Bank of Ecuador is now using the tool, along with economic data, to study how floods and droughts affect inflation dynamics. It has discovered that floods on the coast have the strongest direct effect on local food prices. But droughts in the highlands produce a less immediate, though more persistent effect, boosting inflation for much of the subsequent year. That finding will allow policymakers to improve early warning systems, detect emerging supply pressures, and help households and firms adjust their decisions.

Ecuador is an example of a small, agriculturally dependent economy where extreme weather events affect agricultural production and disrupt supply chains, a challenge that is exacerbated by the fact that the country has a fully dollarized economy and thus limited instruments to offset supply-driven inflation.

Those realities compelled the country’s central bank to use the IDB database to study the magnitude and persistence of the inflationary effects of environmental shocks as well as the extent to which these effects spread beyond the region in which the shock originates, transmitted through the national supply network.

How Environmental Shocks Are Measured

To measure these shocks, a forthcoming study by the Central Bank of Ecuador constructs regional indices based on extreme rainfall conditions. Local weather events are subsequently aggregated to the canton level and grouped into the coastal and highlands regions. The final index weights each canton by its share in regional agricultural output. This renders the measure more policy-relevant, since it captures not only where environmental events occur, but also whether they affect the areas that matter most for food supply and, consequently, for inflation dynamics.

To estimate how prices respond over time, the study uses the Local Projections method to show, month by month over the year following an environmental event, how much food prices have cumulatively moved in response to it. Unlike a single average effect, this approach captures both the immediate impact of a flood or drought and the duration of the impact.

The estimations also control for normal seasonal price patterns and for recent inflation. As a result, the responses can be more clearly attributed to the shock itself, and the results are reported together with 95% confidence bands. This approach isolates the effect of each type of environmental event by region. It allows the effect of each shock to be identified more cleanly and reduces the risk of conflating it with other weather events occurring concurrently elsewhere in the country.

Local Environmental Shocks Can Influence Nationwide Inflation

The results can be summarized in three messages, organized by geographic scope.

1. Local Direct Impacts: Floods on the coast exert the strongest direct effect on local food prices, raising regional food inflation over the five months following the event before gradually easing. Droughts in the highlands, by contrast, produce a less immediate but considerably more persistent effect: inflation builds gradually and remains elevated for much of the subsequent year.
2. Interregional Spillover Effects: Environmental shocks do not remain confined to the region in which they originate. Floods on the coast also push up food prices in the highlands, with an effect comparable in size to the direct regional impact. Highland droughts likewise raise food prices on the coast. These spillovers reflect the strong integration of Ecuador’s food distribution system and confirm that environment-related inflation risks are national in scope, even when the underlying shock is regional.
3. National Level Effects: At the national level, both coastal floods and highland droughts raise food inflation, yet only highland droughts exert a clear effect on headline inflation, reflecting their greater persistence and the longer time they take to pass through from food prices to the broader basket.

Anticipating and Communicating Environmental Effects on Prices

For monetary authorities, such analyses underscore the importance of having a strong ability to anticipate, measure, and communicate environmental risks to prices.

In economies with an active monetary policy, this can help central banks assess whether an environmental shock is likely to be temporary or persistent and adjust their policy stance accordingly. In a fully dollarized economy such as that of Ecuador, where conventional tools such as interest rates and the exchange rate are not available, this anticipatory capacity is even more important. It can empower the central bank to provide a timely assessment and clearly communicate inflation risks, helping anchor expectations while informing policy coordination in the process.

The findings highlight three key policy issues:

1. Integrating Environmental Risk into Regular Economic Analysis: Environmental indicators should be systematically incorporated into inflation monitoring and short-term forecasting exercises. This includes tracking extreme weather events, identifying their geographic concentration, and linking them to key food supply chains. Doing so can improve early warning systems and allow policymakers to detect emerging supply pressures before they are fully reflected in prices.
2. Strengthening Forward-Looking Assessments of Inflation Dynamics: Environmental shocks affect prices with different timing and persistence. Distinguishing between short-lived disruptions and more gradual but prolonged effects is critical for policy decisions. A forward-looking approach that tracks how shocks evolve over time can help assess whether inflationary pressures are likely to fade or persist, and better inform the appropriate policy response.
3. Enhancing Communication of Environment-Related Inflation Risks: Clear and timely communication can play a central role in managing expectations, particularly when policy tools are limited. Explaining the nature of environmental shocks, their expected duration, and their potential impact on prices can help households, firms, and other policymakers adjust their decisions. Over time, integrating environmental risks into regular communication frameworks can strengthen credibility and support more effective coordination across institutions.

This research, conducted at the Central Bank of Ecuador, shows how environmental risks can affect central banks’ core mandates of price stability and financial stability. Related experiences from Ecuador and other countries in the region are discussed in a recent IDB publication, Environmental Financial Risks: A Central Banking Perspective. 

As environmental risks become more frequent, strengthening analysis and early warning systems can help policymakers make more informed economic decisions and better anticipate inflationary pressures.