Marcellino investigates the impact of severe weather on financial stability

Interest in the connections among severe weather events, the economy, and financial stability has risen among researchers and policymakers. While an expanding literature seeks to quantify the macroeconomic impact of severe weather on the US macroeconomy, there remains a paucity of research that formally integrates the financial system into these assessments. A recent paper coauthored by Massimiliano Marcellino, director of Baffi Centre and Asset and Risk Management (ASSET) Research Unit Director, aims at addressing this lacuna. The paper, entitled “Severe weather and financial (in)stability)” was written by Massimiliano Marcellino, Claudia Foroni, Paolo Gelain and Marco Lorusso and has just been published in the BAFFI Working Papers Series (available on SSRN and REPEC).

Severe weather shocks have a negative impact on real and financial US variables, sizable only in periods of financial instability, but muted effects on nominal variables. Moreover, severe weather shocks are never a relevant source of business cycles fluctuations and transmit mainly via a deterioration in the quality of capital.

The study quantifies the effect of severe weather shocks on the US economy in an environment in which the economy can switch between periods of financial stability and financial instability, like the Great Recession.

The authors estimate a New Keynesian dynamic stochastic general equilibrium (NK DSGE) model with banks and severe weather events. The model explicitly takes account for the non-linear relationship that might exist between financial instability and severe weather events. In fact, it is reasonable to expect that periods of financial instability might be associated with a bigger impact of weather shocks. The intuition is that the negative consequences of shocks are more pronounced when banks are already under stress, that is when the banking sector is particularly vulnerable, at the moment the shock hits.

To capture all this, the authors of the paper estimate the NK DSGE model under the assumption that the economy can switch between two regimes, one characterized by financial instability and one by financial stability.  The use of a NK DSGE model has the advantage of highlighting the channels of transmission through which severe weather shocks propagate, and providing a theory based interpretation of those channels. Moreover, given that they estimate our model, they can establish the most quantitatively relevant channels.

The paper shows that severe weather shocks have a negative impact on the real economic activity, especially on investment. Consistently with that, banks net worth drops and credit premium increases. Severe weather shocks appear to be deflationary, although the effects on inflation are very modest. As a result,monetary policy responds by decreasing the federal funds rate, by few basis as well. In periods characterized by financial instability, the effects of severe weather shocks are stronger for all the observed

variables. Despite that, severe weather shocks are never a relevant source of business cycle fluctuations. The main channel of transmission is through shocks to the quality of capital. The destruction of physical capital impairs both goods producing firms, which produce less, and banks assets side, leading to a deterioration of their balance sheet and of the borrowing and lending activity. That gives rise to the accelerator mechanism.

Finally, an analysis of different types of weather events reveals that temperature and sea level shocks drive the largest GDP contractions.