Rising food prices and the dangers of imported inflation

When UK Chancellor Alistair Darling wrote to his finance minister colleagues on ECOFIN last month he made the case for reducing agricultural trade barriers and EU farm subsidies as a way of addressing what has become known as the ‘global food crisis’. Quite rightly much of the world’s attention has been focussed on the impact of rising food prices on the world’s poor. But a more motivating factor for the UK could be the fact that higher food prices presents the UK economy with the very serious problem of imported inflation.

Yesterday the Governor of the Bank of England wrote a letter to the Chancellor explaining why the UK had exceeded the inflation target of 2 per cent and had reached 3.3 per cent. The letter cites the cause as “unanticipated increases in the prices of food, fuel, gas and electricity”.

The UK runs a large trade deficit in food and agricultural products, at around 22 billion euros or 13 per cent of GDP (see table below). This makes global food price increases especially damaging for reasons that I’ll explain below. By contrast, France runs a trade surplus in food of almost 5 per cent of GDP. For net food importing countries the rising cost of food is just as bad for consumers as in net food exporting countries, but it is less pernicious for the economy as a whole since more of the increased cost of food will accrue as increased income for French farmers, as opposed to leaving the country altogether.

Imported inflation is worse than what might be termed ‘home grown’ inflation because it represents a net drain on the economy as a whole and it is harder to cure by raising interest rates, the traditional curative for home grown inflationary pressure. Since UK interest rates have zero effect on the world price of food they are useless as a way of controlling food prices. Worse still, imported inflation causes a depreciation of sterling, which further erodes the population’s purchasing power vis à vis imports.

Since people cannot do without food, when food prices go up they will either have to spend less on something else (consumer goods, leisure, saving) or ask their employer for a pay rise. Wage inflation (known as a second round effect) is likely to provoke a response from the central bank in the form of higher interest rates, which will slow economic growth and send the economy further towards recession. Imported inflation plus successful claims for wage rises, and thus further increases in producer prices, higher interest rates and less economic growth is the toxic cocktail known as stagflation, a feature of many economies in the late 1970s following the oil price shocks.

So what should be done? The first task for central banks is to evaluate the nature of the rise in food price: is it a one-off increase or a long term trend? If it’s a one-off increase it can much more easily be set aside. Central banks need to decide whether to focus on ‘headline inflation’ (CPI, RPI or any number of other flavours) or ‘core inflation’ (which generally excludes things like fuel and food, due to their highly cyclical nature and the fact that their prices are determined on world markets). The US Federal Reserve has a reputation for focusing on core inflation while the Bank of England has a remit to keep headline inflation at or around 2 per cent.

Chris Allsopp, a former member of the Bank of England’s monetary policy committee, now director of the Oxford Institute for Energy Studies is quoted in The Observer as endorsing a the view that core inflation should be the target of monetary policy, not headline inflation:

“So far, as far as I can see, though we have had a lot of headline inflation, a very large proportion is actually due to the feed-through of oil prices and food prices, and the standard, conventional response is to let through those effects.”

The second task for central banks is to assess whether food price rises are likely to result in successful claims for wage increases. This in large part depends on the willingness of employees to hold out for higher wages as opposed to accepting real terms cuts to their wages as a result of higher food prices. A lot of this comes down to psychology and expectations about the future prospects of the economy. If people feel that the economy is heading for a fall and that any job is better than no job at all, they may be willing to accept that they’ll be less well off as a result of rising food prices. The slump in the housing market triggered by the global credit crunch is already contributing to the notion of economic gloom that may dissuade people from pressing for big wage increases. The decision of the ministers of the UK Government to forgo their annual pay increase suggest that they are hoping to spread the idea of wage restraint among the rest of the population. The Governor of the Bank of England indicated that ‘pay growth has remained moderate’ and an economic slowdown is already ‘in train’ and that this will dampen the pressure for ‘second round’ wage and price rises.

The problem is that the harmful impacts of food price rises fall most heavily on the poor, for whom food represents a higher proportion of household outgoings. Thus food price rises are very regressive, and there is every chance that poor people will be facing very tough choices: whether to eat or to heat their homes or whether to feed or clothe their children. In the UK this looks likely to set back the government’s progress towards meeting its high-level targets of reducing child and pensioner poverty.

In the long run the only sure way to get food prices back down is to increase agricultural productivity, and the best way to do this is by research and investment in agriculture, especially in parts of the world where productivity is lagging behind (such as in sub-Saharan Africa). The problem is that this kind of policy takes a long time to come good. We may be stuck with higher food prices for a long time to come, and in the mean time governments would be wise to use redistributive flanking measures to protect the purchasing power of the poorest and most vulnerable.

Further reading:

ITEM Club Special Report – Food For Thought: How Global Prices Will Hit UK Inflation and Employment.

HM Treasury: Global commodities: a long term vision for stable, secure and sustainable global markets