Food prices may feed monetary angst

July 13, 2012

Be it too much sun in the American Midwest, or too much water in the Russian Caucasus, food supply lines are being threatened, and food prices are surging again just as the world economy slips into the doldrums.

This week, Chicago corn prices rose for a second straight day, bringing its rise over the month to 45%, and floods on Russia’s Black Sea coast disrupted their grain exports.  Having trended lower for about nine-months to June, the surge in July means corn prices are now up about 14% year-on-year. And all of this after too little rain over the spring and winterkill meant Russia, Ukraine and Kazakhstan’s combined wheat crop would fall 22 percent to 78.9 million tonnes this year from 2011.

But as damaging as these disasters have been for local populations, their effects could be much more widely felt.

The problem is that not only do rising food prices raise the cost of living, squeezing incomes further during a downturn, but by raising inflation they severely restrict the government’s flexibility in setting monetary policy. Just as Mike argued previously on this blog that the falling oil price amounted to a green light for the cutting of interest rates, rising food prices will force many central banks to think again about the pace of monetary easing.  And the problem is most acute in developing countries where the proportion of food in consumer price baskets is far higher than in the richer western economies. For example, according to the US Department of Agriculture, an additional $1 added to income sees 56 cents more spent on food, beverages and tobacco in Burundi, compared to 5 cents more in the United States.

The Russian central bank is a timely case in point when it comes to restrictions on monetary policy. On Friday they announced that they were keeping interest rates the same; as much as growth is struggling and could do with some monetary stimulus, high inflation, fuelled by food prices, is tying the bank’s hands.

Why has this happened? According to the traditional Phillips curve, there is usually a tradeoff to be made between unemployment and inflation; they are inversely related, as prices and wages will rise when unemployment is low, and vice versa.

However, rising supply side prices such as oil or food are incredibly costly because they are “cost-push shocks”, which increase prices for any given rate of output. This means that even if there’s an output gap, and high unemployment, cost-push shocks can increase inflation, contrary to the expectations of the Phillips curve. High inflation and high unemployment leaves monetary policy needing to act in two different directions.

There’s another related reason why emerging market prospects seem bleaker on this news, however. According to Rencap, in a note to clients on Thursday:

EM debt has been one of the most favoured asset classes globally in the past 2-3 years… It has been our view that falling debt yields would eventually encourage investors to turn from debt to equity – as they hunt for yield. This would be a reverse of the move from equity to debt that occurred in late 2008 when equity investors discovered good returns and safer assets in EM debt markets. Now the risk of higher inflation weakens the bullish case for EM local debt, even if it has little meaning for EM hard currency debt. Higher inflation over the coming 12 months will make interest rate cuts harder to justify in Russia for example. It should be negative for Mexican local government bond yields – they like their corn chips in Mexico.

Emerging debt has performed well this year, with local currency debt racking up returns of 6 percent year to date, while dollar bonds have returned almost 10 percent. Data from EPFR shows investors have poured over $14 billion into emerging debt funds so far this year. With higher inflation, investors will demand higher yields on their bonds, providing another reason why interest rates will prove harder to cut.

Just as Russia benefits from higher oil prices, some arable crop exporters may benefit from this price rise. But for emerging markets in general, the costs certainly stand to outweigh the benefits.

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