Food prices matter, here’s why

Wednesday, 28 May 2014 00:03 - - {{hitsCtrl.values.hits}}

By Paul Donovan Reuters: Investors are cautiously starting to examine the topic of food price inflation once again. The United States recently saw a sharp rise in producer price food inflation. Further down the economic development ladder, producer prices for the food manufacturing industry of China have been steadily creeping higher from the lows reached two years ago. Food prices in Japan have increased at the fastest pace in four years, helped by the weaker yen. Korean producer price inflation for food products has been rising for a year. Food producer price inflation for Malaysia has edged up.

So far only the United Kingdom and the Euro area have clearly defied this drift towards higher prices. In the Euro area, the economic recovery is still relatively weak so labour costs and consumer demand are both subdued. The stronger Euro has also helped to lower agricultural commodity prices in Euro terms. That combination suggests more subdued domestic food price inflation. The United Kingdom does not have quite the same situation (although the pound sterling has been relatively strong), but food price restraint receives the added incentive of a general election next year – food pricing is a politically sensitive topic. Investor attention has also been caught by a mild upward drift in the price of internationally traded agricultural commodities. Investors need to be careful about how they interpret such information – most agricultural commodities are traded internationally, but instead are confined to domestic markets with regulated prices. However, local agricultural prices are rising too: prices paid to farmers in the United States have been rising more rapidly for instance. It is also important to remember that commodity prices form only a very small part of the price of food that the consumer ends up paying for – the most important part of food pricing is labour costs paid for the transportation, processing and distribution of food after it has left the farm. Overall, there is enough movement in food prices to put the issue onto the investment agenda. It is wise to pay attention to these food price increases, because unlike the two instances of higher food price inflation, in 2008 and 2011, food price increases today have the potential to have a wider, indirect impact on the economy.

The economic problem with food is that consumers believe food matters more than it does. This is not to deny the importance of food in itself – even economists must eat to live. What it means is that consumers tend to assume that far more of their household budget is allocated to food than is actually the case, and that the price of food is more relevant to overall inflation than it actually is. This is because food is a high frequency purchase, so consumers are constantly reminded of the price. Someone is quite likely to remember what they paid for food last week, while they will forget the price that they paid for a television two years ago. The result of this is that consumers’ perceptions of inflation are strongly tied to food prices (the other influential price for consumer inflation perceptions is the price of fuel). If food prices continue to rise, then consumers are quite likely to believe that inflation is rising faster than it actually is. This is exactly what happened in 2008 and 2011. Consumers thought that there was more inflation than there actually was. In 2008 American consumers thought inflation was set to rise by almost 8 percent over the next twelve months (US consumer prices actually fell 1.3%) and in 2011 the expectation was almost 7% inflation over the coming year (it rose just 1.7%). There is one important difference between 2008, 2011 and the economic circumstances of 2014. In 2008 and 2011 labour markets were generally weak. There was a fear of unemployment, and wages were subdued. If consumers thought (wrongly) that inflation was going to be high, there was not that much they could do to offset that. In 2014 this is less likely to be the case. Several countries, notably the United States, have seen a fall in unemployment. Workers believe that they have greater job security, and can negotiate better pay.This means that although food price inflation may be less than it was in 2008 and 2011, the combination of food price inflation and a better labour market may lead to wage pressures that were absent in the two earlier food price inflation episodes. This, in turn, may require some kind of response from central banks – particularly in an environment where interest rates are starting from such low levels. Investors would be wise to pay attention to food prices. (The views expressed in this column are the author’s own and do not represent those of Reuters)