Friday, April 18, 2008

Behind the Food-Price Riots

From the Wall Street Journal: By VINCENT REINHART, April 18, 2008

With a dramatic rise in the prices of foodstuffs, riots have flared up in dozens of hotspots around the world. Panicky politicians are responding with precisely the wrong policies, including production subsidies and trade controls.

The problem is clear enough: According to the International Monetary Fund, food and beverage prices have risen 60% in the past three years, and more than doubled since 2001. Even in the U.S., increases in the food-price component of producer- and consumer-price indexes over the last 12 months have been in the neighborhood of 5%.

What is going on? We can discern four forces at work today pushing up food prices – forces that were also at work in the 1970s, the last time food prices increased so rapidly on a sustained basis:

- Monetary policy in overdrive. Consider the real federal funds rate – that is, the nominal funds rate less inflation. A low real fed funds rate both encourages interest-rate sensitive spending, such as business investment, and discourages global investors from supporting the dollar on foreign exchange markets. At 2.25%, the nominal fed funds rate is now below the prevailing rate of consumer price inflation.

The last time the real fed funds rate was negative for a prolonged period was the mid-1970s. This was also a period when overstimulated demand pushed food prices up and the dollar depreciated sharply. In the end, economic growth suffered as well. Remember stagflation?

- Exchange-rate arrangements in disarray. The 1970s were also noted for turmoil in exchange markets, following the breakdown of the Bretton Woods system. The schism today is that some exchange rates move too little and others too much.

The exchange rates that are moving too little are those of emerging market economies and oil producers. China, India, Korea and Taiwan, and key oil producers such as Saudi Arabia, have been preventing their exchange rates from appreciating significantly by rapidly accumulating international reserves.

They've also effectively adopted the monetary policy of the Federal Reserve by keeping their domestic interest rates close to the fed funds rate. That way, no interest-rate wedge opens between their markets and our own that would otherwise put pressure on their exchange rate. As a consequence, they are following an accommodative monetary policy strategy totally unsuited to their already overheated domestic economies. Higher inflation has followed.

With exchange-rate movements capped by policy makers in so many parts of the world, the burden of adjustment falls more heavily on the nations that allow their currencies to float freely, such as Canada, those in the Euro area, and Japan. The depreciation of the dollar against these currencies is yet another reminder of the 1970s. As a result of these exchange-rate changes, the purchasing power of these regions for any internationally traded good denominated in dollars has gone up. Hence, it is no accident that the dollar price of food is up sharply.

- Unsound market interventions. Policy makers flailed about in the 1970s, enacting environmental legislation without due deference to the costs imposed on industry. They also tried to impede market forces with gasoline rationing and a brief flirtation with outright price controls.

This time round, our government has been force-feeding the inefficient production of ethanol. The result: Corn prices have more than doubled over the past three years, adding to price pressures on commodities that are close substitutes, or which use corn as an input to production.
Meanwhile, policy makers in emerging market economies have bent under the weight of popular unrest to raise food subsidies. This strains their budgets. They are also imposing restraints on exports, thereby losing gains from trade.

- Oil prices on the rise. The lines stretching around filling stations in the 1970s should remind us that large energy-price increases are disruptive. And we have had a large one: Crude prices have more than quadrupled since 2001. Any industry dependent on energy will feel those cost pressures, and modern agriculture, with its oil-based fertilizers and large machinery, is no exception.

But there is an important difference between our troubles today and those of the 1970s. In that decade, aggregate supply sagged as oil producers scaled back production and anchovies disappeared off the coast of Peru. The 2000s have been about demand expansion. Millions of workers in China, India and Vietnam, among others, have joined the world trading system. Beginning from a point close to subsistence, most of their additional income is being spent on food. Thus, the price of food relative to other goods and services has risen.

The good news is that producers respond to relative prices, although it can take some time. Already, the acreage in which corn is planted in the United States is back to levels of the 1940s. More of a production response should follow in other areas as well.

Challenges abound as supply catches up with higher global demand. The Federal Reserve has to be sensitive not to stoke inflation pressures, and to monitor inflation expectations closely. The subsidies proffered to corn producers have to be trimmed, in part to set a new standard for emerging market economies to emulate. And the gains from an open trading system have to be protected to keep our economy efficient.

Mr. Reinhart, a resident scholar at the American Enterprise Institute, was director of the Division of Monetary Affairs at the Federal Reserve.

Here is a Canadian perspective on inflation.


Alan said...

#5 - grain feed livestock.

Roberto said...

Got Gold?

BobbyBear said...

Since the top around 1980-81 interest rates dropped to their low in 2003 and then rebounded and dropped again to current levels.

The mortgage rate stimulation tool is essentially over since they really cannot go lower, at least very little.

The Fed now has to inject liquidity into the economy as this is now their real only tool. Some equate this to printing money. Fair enough...same result really.

Alas, too much money starts to bid up the prices of commodities which we have seen now for several years.
Wheat, oil, copper and so forth have been rising substantially.

If The Federal Reserve continues to add liquidity to the economy, price inflation will continue which ultimately will lead to higher prices acroos the board as well as increased pressure for wage gains.....a very dangerous cycle.

Will they? Right now it is difficult to see The Fed being aggressive against inflation. It is not out of control and the subprime/housing problem is their main priority at the moment.

Yes, the Fed Funds rate is below the rate of inflation and will stay below it for at least a while for a few different reasons. Only when inflation is deemed a true threat will they act.

Right now the largest threat is economic downside. The unemployment rate is increasing as layoffs start their growth cycle.

Previously, when mortgage rates could be lowered, this was a driving force behind the economy since a mortgage rate reduction went directly to the homeowner. With the liquidity injections, the money is not targeted anywhere particular but simply enters the system.

With inflation, the danger is that "inflationary expectations" begin and commodity hording becomes a potential problem. My guess is that there is a substantially hording mentality in existance.

Who knows for sure. Have a great weekend.

patriotz said...

forces that were also at work in the 1970s

Man I was wondering why I keep hearing "Staying Alive".

The inevitable result of inflationary monetary policy is higher interest rates. Lenders will eventually say "enough" and start putting money into commodities (and gold) instead. Central banks cannot control open market interest rates.

If you think RE has a long way to fall at current rates, just imagine 10%. Or more.

mohican said...

that is a very good point patriotz.

The real estate market is already in 'correction mode' and lets imagine that interest rates stay low for the next two years while prices correct 20%. Now imagine that open market interest rates start rising to cover investor's inflation expectations/reality. What will happen to house prices then?

The formula I posted earlier this week gives us a rough idea of what would happen to house prices. I suggest everyone find out what the fair value of that house is with today's rate and then punch in a 10% rate. Wowza! You'll be shocked.

The issue is that we could be in a situation in which real estate prices fall at today's low rate and then we get kicked in the teeth while we're down with high interest rates due to inflation.

BobbyBear said... is serious, no question about it. Too much inflation and interest rates may start heading higher.

A doubling of interest rates over 5 years, as an example, would essentially cut the value of a house or condo in half. This does not include higher inflation, rising unemployment and negative perception into the equation.

We have had a great party. Tougher times certainly are around the corner.