Food Chain: Do Spiking Food Prices Warn of Generalized Inflation?
by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
February 14, 2011
Key points
- Food inflation heats up and incites global unrest.
- But for now, it's unlikely to become a monetary phenomenon.
- Investors should expect geopolitical risk to stay elevated in 2011, with implications for emerging markets performance.
Inflation is back as a big concern … for some it never waned. The subject has headlined many of my reports during the past couple of years; since the Federal Reserve began pumping unprecedented sums of liquidity into the financial system in 2008.
Recently, it's the shocking spike in food and, to a lesser degree, energy prices that has elevated the worries again that "core" (excluding food and energy) inflation will follow.
The recent troubling spike in food inflation, seen in the chart below, has its roots in major supply disruptions caused by extreme weather conditions in many of the largest food producing countries. But it's also a function of booming emerging economies and the rise of their consumer population.
Skyrocketing Food Prices
Click to enlarge
Source: Commodity Research Bureau (CRB) and FactSet, as of February 11, 2011.
Geopolitical implications
Rapidly rising inflation can be toxic not only to economies, but to profit margins and stock market valuations, as well. It's also becoming toxic to the social fabric in countries where food is a large portion of consumers' expenditures, like in emerging Asia (see chart below).
Unless food and fuel prices begin to ease, there are implications for Asia's debt outlook and also for leaders hoping to prevent another Egyptian-style uprising; which had at its roots unrest about food prices and unemployment.
Emerging Economies' Food Consumption
Click to enlarge
Source: Wolfe Trahan & Co. Portfolio Strategy, as of February 14, 2011. Chart uses region average.
The United Nations estimates that countries spent at least $1 trillion on food imports last year, with the poorest nations paying about 20% more than in 2009. Asian governments are expected to increase subsidies and cut import taxes, with potential important fiscal implications. This is on top of the social instability risks that the world watched in Egypt during the past several weeks.
Unlike the commodity price spike in 2008, that had a large speculative component to it, this one appears to be less cyclical and more secular. Asia's diet is becoming more Western, with a greater focus on dairy and livestock, and less focus on its historic staples.
Rising commodity prices are making it difficult for China's central bank in particular, but also in India and Indonesia, among others. Expect much tighter monetary policy in the region, which has implications for emerging markets performance. We continue to believe investors should not be overweight emerging markets relative to their strategic targets.
In fact, in addition to the fund flows coming out of bonds in reaction to the latest spike in Treasury yields, we think outflows from emerging markets could find their way to US stocks.
We do have some budding concern that there could be some upward pressure on core inflation in the United States, too, but think the implications of rising headline inflation will be felt more acutely in the emerging markets, both economically and socially.
Too much … too few
The late, great Milton Friedman once proclaimed that inflation is best defined as "too much money chasing too few goods." Many are making the "too much money" argument because of the massive liquidity in the financial system. But that money remains stuck in the banking system, as we'll discuss shortly.
Now it's also the "too few goods" argument that is being made because of food shortages. But the real question for US monetary policy is whether the conditions are in place for general price inflation to take hold.
Given the tremendous amount of excess global capacity and limited upside wage pressures, core inflation risk in the developed world remains relatively benign.
The latest core inflation readings are:
- 0.8% in the United States (see chart below).
- 1.1% in the euro-zone.
- -0.7% in Japan.
- Even China's core inflation, though higher than the aforementioned regions, is at a reasonable 2.1%.
Core Inflation in Check … For Now
Click to enlarge
Source: FactSet, as of December 31, 2010.
Many argue that it's only a matter of time before core levels of inflation begin to heat up, given liquidity overflows. But Bank Credit Analyst (BCA) notes that developed world central banks have not been able to create a "money glut." Money supply (M2) growth in the United States is up, but only 4.3% year-over-year. For the Organisation for Economic Co-operation and Development (OECD) as a whole, broad money is only growing at a 1.2% annual rate. An acceleration would likely put upward pressure on inflation expectations, so money supply growth rates need to be watched carefully.
More velocity needed
In reality, all that developed world central banks have accomplished is to free up reserves in their banking systems, little of which is getting passed through the lending channels to feed into the economy.
This is the concept of the "money multiplier" about which I've written extensively. The math behind what's also called the "velocity" of money is dividing M2 money supply by the overall monetary base (currency in circulation plus banks' required and excess deposits at the Fed).
When it's low as it is presently, core inflation risk is benign. This is one of the key metrics we're watching to see if inflation risk is increasing.
Velocity of Money on Floor
Click to enlarge
Source: FactSet and Federal Reserve, as of February 4, 2011.
No wage-price spiral in sight
Another precondition for core inflation to erupt is excess wage growth and/or rising unit labor costs. This is the so-called "wage-price spiral" inflation that characterized the late 1970s and early 1980s. As you can see below, neither is highlighting trouble on the horizon.
Muted Wage Pressures
Click to enlarge
Source: Department of Labor and FactSet, as of December 31, 2010.
No Unit Labor Cost Pressures
Click to enlarge
Source: Department of Labor and FactSet, as of December 31, 2010.
As BCA points out, wage growth exceeding labor productivity is what triggered the wage-price spiral in the 1970s. In the mid-1970s, the difference between the two was 18%, while today it is barely in positive territory (up from negative territory in 2009).
The tax effect
Let me state the obvious by noting that rising food and energy prices do have an economic impact as they act as a tax on the consumer, which drains discretionary spending power. But as long as wage and unit labor cost growth is in check, there is unlikely to be widespread ability to pass along rising input costs to the end consumer. Rising commodity prices can't create pricing power where it didn't exist before.
That doesn't mean there aren't certain companies and/or industries that are having some success and this bears careful watching. The National Federation of Independent Business survey of small business price plans increased to 19% in January versus its recession low of 0% (it was 30% in 2007).
The airlines also announced price increases last week, along with a couple of large consumer products companies. Finally, University of Michigan's survey of consumer inflation expectations rose to 4.5% in the first half of February versus its recession low of 1.7%.
What would trigger general price inflation?
We are starting to see an increase in bank lending, both for commercial and industrial (C&I) and consumer loans. A more sustained increase would cause the velocity of money to begin accelerating. Frankly, this is a necessity for a sustainable economic expansion, but it would also increase core inflation risk.
In addition, because emerging markets are behind much of the spike in commodity prices, it puts pressure on goods' prices that are transported across borders. Clearly, producers of these goods have incentive to sell into inflating markets, so prices received are higher.
They will likely only sell to US dollar-based consumers if the US dollar price received is commensurate with the price in the inflating emerging markets. This could result in shortages, exacerbated by rumored hoarding, which would mean higher prices absent an increase in the velocity of money.
The hope is that the size dominance of the developed consumer markets versus the emerging consumer markets will prevent sufficient goods to flow to high-inflation markets to significantly increase generalized inflation risks globally.
The China Syndrome
China is at the heart of the inflation scare and bears close monitoring. Given its robust economic growth and excessive credit growth, the risk of food inflation passing through to general price levels is high and rising. It is somewhat tempered by monetary policy tightening and the fall in China's leading economic indicators in reaction.
As BCA notes, if history is any guide, inflationary pressures could crest sooner than later alongside a slowing economy. China's wage growth is about 16% year-over-year, roughly in line with productivity growth in the modern sector. This is the principal reason why core inflation has stayed low.
Fed reaction function
Traditional monetary inflation is not yet spreading in the global economy with limited wage growth not only in the Untied States, but in the G7 more broadly. And G7 productivity growth remains healthy. This should keep developed country central banks largely accommodative.
We do worry the Fed will remain accommodative too long though. As we've noted, we believe the US economy is well past the emergency phase that pushed the Fed to lower short rates to zero.
Expect the criticisms about too-easy monetary policy to persist with every uptick in commodity prices. Cries of the Fed being "behind the curve" will likely get a volume boost this year.
In the shorter term, it's likely the social and economic implications of what we're seeing with commodity prices that will continue to be the big story.
Important Disclosures
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative (or "informational") purposes only and not intended to be reflective of results you can expect to achieve.
